EU Bank stress tests to become more useful to investors
EU banks’ supervisory stress tests are set to become more useful to investors as the results will now have a clearer influence on banks’ capital management decisions, Fitch Ratings says.
The ECB recently announced that Pillar 2 Guidance (P2G) capital buffers will be more explicitly linked to the banks’ capital depletion under its ‘adverse scenario’. The new linkage, which is largely formulaic, will help investors to immediately assess and quantify the likely P2G implications of stress-test results. It will also help banks set their capital management and dividend policies with more confidence.
Banks that performed well under the latest stress test may decide to ease some of the caution built into their capital management policies as they will have greater certainty over their resulting P2G than under the previous less transparent approach.
However, we expect most EU banks to maintain a disciplined approach to capital, and a modest easing of capital caution would typically not put pressure on ratings. For most, capital is strong relative to ratings, which are typically constrained by other factors, such as business profile or profitability.
Some banks that perform poorly under stress tests could face increased P2G under the new approach, once pandemic-related measures allowing banks to operate below the P2G level expire, potentially from end-2022. However, a higher P2G buffer is unlikely to be credit positive if the capital increase is simply to address risks and vulnerabilities uncovered by the stress test.
Until now, the relationship between EU banks’ stress-test results and the ensuing supervisory actions has been opaque, with a significant delay between the two. This is in contrast to the US, where stress-test results and follow-up actions are announced simultaneously. The ECB’s announced approach appears closer to the US process.
The ECB unveiled its new approach on 30 July, just two days after the European Banking Authority issued a consultation proposing to set the level of P2G based on buckets set around the maximum capital depletion under stress tests.
Banks are put into one of four buckets, according to how severely their capital is depleted under an adverse stress scenario. Each bucket defines an indicative P2G starting point range, with some overlap between the ranges to avoid cliff effects.
Joint supervisory teams then exercise their expert judgement to pinpoint each bank’s P2G within the range corresponding to its bucket (or, in exceptional cases, beyond the range of the bucket), taking account of banks’ individual risk profiles. For example, if certain risks under the stress tests have already been addressed by a bank’s capital requirements, they may not need to be additionally factored into its P2G.
EU bank supervisors do not currently publish P2G and the ECB has not announced any change in disclosure requirements, so banks’ P2G may remain private unless they disclose it voluntarily (as some already do).
The ECB will continue to allow banks to operate below P2G levels until at least end-2022 but we expect banks to take the new methodology into consideration well before then as part of their capital management planning.