EU flag

As the European Central Bank prepares to take over regulation of the financial sector for the first time as part of the Single Supervisory Mechanism, firms across the continent will be feeling the pressure from the European Banking Authority stress tests.

The stress tests will establish how banks hold up under normal and adverse conditions before the ECB becomes official watchdog in November.

The adverse scenarios that banks will have to hypothetically withstand include a slump in global debt markets, a rise in funding costs, a recession and plummeting property and equity prices.

This year's tests are said to be the toughest the EBA has imposed to date, and there is a chance that banks will fail the tests as many are still under-capitalised across Europe, and this is likely going to come out as a result of this process.

Tactics vs Strategy

Given the short time frame and host of other regulatory requirements in place, many banks have addressed the stress test requirements from a tactical standpoint, rather than strategic.

This approach may be adequate for the short-term in addressing this round of the EBA's stress test, but given that stress tests are at the heart of risk management practices today and recur regularly throughout the year, banks will need to address the requirements strategically, if they are serious about strengthening their business while also meeting regulatory demands.

One way of achieving this is by aligning risk and finance functions allowing firms to benefit from faster and better quality data, providing a clear picture to regulators as well as senior management and key decision makers internally.

The ECB wants to know that it is taking regulatory control of a European financial sector which is resolute to any future stresses, so it has put some weight into its first round of stress tests to ensure proper action can be taken, where needed.

It also needs to tackle a general scepticism towards the efficacy of stress testing to date, thanks to the EBA's somewhat underwhelming track record. For example, an EBA stress test of Franco-Belgian firm, Dexia, gave it a clean bill of health shortly before it collapsed in 2011.

Concerns have grown around how the ECB will take into account bank-specific portfolios.

All banks are different and comparisons are hard to draw upon, and this is never truer when supervising the Eurozone as the ECB intends to do.

Finally, following the ECB announcement in July this year around its disclosure processes, banks are concerned about the amount of information the ECB is set to publicly disclose when it publishes the results of the comprehensive assessment.

The Effectiveness of Stress Tests

Regardless of the criticism, stress tests are only as effective as the underlying models and assumptions, and the results very much depend on this.

The EBA will test banks in this round of stress tests on a common set of risks, such as credit risk, market risk, sovereign risk, securitisation and cost of funding. Currently, there is no requirement to run liquidity tests. The test will also stress both trading and banking book assets.

Those firms that have aligned their stress testing processes to not only the regulatory requirements, but also business strategy and budgeting, will be more resolute and successful.

For this round, the test will be conducted on the assumption of a static balance sheet. This is one area that differs from the Bank of England's own stress test exercise, which is based on a dynamic balance sheet and thus represents a more challenging test. Many anticipate that the EBA will switch to dynamic testing and expand on the risk coverage of its tests in the future however.

If the results show that some banks have failed the tests, it may be viewed as a double-edged sword.

On the one hand, it is positive to see that the new supervisory framework is tougher than its predecessor, but on the other, it shows that some banks are still potentially susceptible to adverse conditions, thus running the risk of defaulting.

With the ECB's desire to demonstrate that it is up to the job of strengthening regulation, supervision and risk management of the EU banking sector as chief regulator, combined with the level of challenge posed by the EBA's latest round of stress tests, there is a real chance that some banks will fail to meet the standards.

What the ECB does after is perhaps more significant, and firms can expect tougher requirements levied on them as firms move through further rounds in this three-year stress test exercise.

Nancy Masschelein is the vice president of market management finance and financial risk at Wolters Kluwer Financial Services.