International Stress Tests

introduction and summary

On 23 July 2010, the Committee of European Banking Supervisors, CEBS, published the results of a stress test of the European banking sector. The test comprised the largest banks in the EU member states.

The purpose of the EU stress test was to assess the resilience of the European financial system against negative shocks to the economy and mitigate financial market uncertainties as to the state of the European banks. Therefore, the total report with aggregated results has been supplemented by the publication by national authorities of bank-specific results and exposures to European sovereign debt.

A total of 91 banks from 20 countries participated in the stress test. Three Danish banks, Danske Bank, Jyske Bank and Sydbank, were among them. At least 50 per cent of total assets in the individual member states' banking systems was to be covered by the stress test. The 91 banks represent 65 per cent of total assets in European banks.

Two scenarios were presented for the economic development, a benchmark scenario of continued recovery and an adverse economic scenario, under which the economy falls back into recession. The scenarios run until end-2011. Focus is primarily on credit and market risks, including risks associated with exposure to European sovereign debt.

Overall, the three Danish banks rank in the top 25 per cent in terms of tier 1 capital ratio, which is the central measure of banks' robustness in the stress test. Seven of the 91 banks failed to meet the 6 per cent threshold of the tier 1 capital adequacy. The threshold has been set by CEBS in accordance with the stress test of the US financial system by the Federal Reserve, published in May 2009.

Stress test results

The stress test focused on credit and market risks, cf. Box 1. The banks' resilience against economic shocks was measured by the tier 1 capital ratio. In the stress test this should exceed 6 per cent during the entire period. This should not be confused with the statutory minimum requirement of 4 per cent. Liquidity risks were not part of the test, but are obviously a factor that should be included in the overall assessment of the robustness of the financial system.

The stress test scenarios were created by the European Central Bank, ECB, and the European Commission. The benchmark scenario was based on the Commission's forecasts from November 2009 and February 2010, updated by the most recent macroeconomic data. The benchmark scenario assumes that the global economic recovery seen in early 2010 continues in 2010 and 2011.

In the adverse economic scenario, the European economy slips back into recession. To reflect the likelihood of a sovereign debt crisis, yield increases on European government bonds have been added with a subsequent decline in the value of the banks' holdings of government bonds.

In the benchmark scenario, the banks' total tier 1 ratio rises steadily over the period to 11.2 per cent at end-2011, cf. Chart 1. Core earnings decline slightly in 2010, but rise again in 2011 to above the level realised in 2009. Write-downs decline steadily during the period.

In the adverse economic scenario, however, the overall tier 1 ratio falls sharply to 9.6 per cent at end-2011, which is due to increased write-downs on loans in particular. Moreover, during the entire period core earnings stand somewhat lower than the level seen in 2009.

When the adverse economic scenario is expanded by a European sovereign debt crisis in the form of higher government bond yields, the tier 1 ratio declines further to 9.2 per cent. This is attributable to capital losses on government bonds in the banks' trading portfolios and major write-downs on loans for households and the corporate sector.

Overall, seven of the 91 participating banks will be faced with tier 1 ratios below 6 per cent during the stress test. These are one German, one Greek and five Spanish banks.

Resilience against loss on sovereign debt
The adverse economic scenario incorporated a specific shock to the government bonds market, in part to reduce uncertainties in the financial markets over the banks' risk. The shock is modelled as a decline in prices of government bonds and thus a yield increase entailing capital losses on the banks' trading portfolios. In the stress test, the capital losses are set on the basis of previous price fluctuations. The capital losses on government bonds from Greece, Portugal and Ireland relative to the market price at end-2009 have been set at 23.1 per cent, 14.1 per cent and 12.8 percent, respectively, during the entire period. In addition to the direct effect on capital losses, the higher yields increase the write-downs on loans to households and the corporate sector.

Danish banks
Macroeconomic developments in Denmark appear from Table 1.¹In the benchmark scenario, the gross domestic product, GDP, is in line with Danmarks Nationalbank's most recent forecast. Unemployment in 2010 in the benchmark scenario more or less matches the current gross unemployment level.

In the EU stress test, all three Danish banks have a tier 1 ratio substantially above the 6 per cent threshold, cf. Table 2. The Danish banks already had a tier 1 ratio above average at the starting point. Furthermore, they do not have significant exposure towards the governments, which suffer the largest capital losses in the stress test – neither in their trading or own portfolios.

Reactions to the stress test

In the period around the publication, the market's assessment of the risks on the large European banks fell, measured by CDS spreads, cf. Chart 2. Moreover, market prices of European banking stocks outperformed general stock indices. The stress test probably contributed to this trend.

It played an important role that detailed information about the banks' profit/loss and exposures was published by the national authorities and the banks themselves in connection with the stress test. Particularly exposures to European sovereign debt attracted attention. The level of detail allowed analysts to prepare their own calculations with other scenarios and/or stress criteria. In Denmark, detailed information about the Danish banks was published on the websites of the banks involved, the Danish Financial Supervisory Authority and Danmarks Nationalbank.

The results of the EU stress test do not change Danmarks Nationalbank's view on financial stability in Denmark, nor do they give rise to the proposal of new initiatives. The stress test increases transparency. This provides for better analysis and assessment of the banks and decisions on a more informed basis, which only improves the discipline exerted on the banks by the capital markets.