An Encompassing Forward-Looking Approach to Increase Resilience in the Banking Sector: A second life for EU Stress Tests

Summary:

The EU-wide stress tests have constituted a very useful supervisory tool for increasing the resilience of the banking sector. This paper is a contribution to the ongoing discussion on the future changes of the EU-wide stress test. The paper outlines an encompassing forward-looking approach (e-FLAIR) to increase the resilience of the banking sector, where the stress test procedure is put in context with many other supervisory tools, including AQRs, revisions of internal models, capital planning reviews, SREP, ICAAP, sensitivity analyses and recovery plans.

The paper claims that the current EU-wide stress test will benefit from the implementation of some changes: moving to a dynamic balance sheet, implementing a predominantly top-down approach, reinforcing the approach to assess capital-adequacy through a swift implementation of the Basel III finalization, overcoming the limitations of a single adverse scenario by considering more than one, by developing sensitivity analyses and by incorporating bank-specific stress tests. Finally, this paper proposes a move to a more balanced capital adequacy-profitability focus in the design of the stress test exercise.