Stress Testing Financial Stability

Department of Economics
Faculty of Economics and Behavioral Sciences

University of Freiburg
Seminar paper in
Financial Stability
Prof. Dr. Martin Goetz

(Goethe University Frankfurt/Main)
Stress Testing: History of Stress-testing

in Europe and the U.S.
Ivan Dyachok
IMP, Finance, 8th Semester
Mart. Number: 3352663
Merzhauser Str 160
79100 Freiburg
Ivan Dyachok, 3352663
Contents
List of Tables ........................................................................................................................ 3
List of Figures ....................................................................................................................... 3
Table of Abbreviations .......................................................................................................... 5
Stress Testing in Europe and the US: Overview................................................................... 7
Design of Stress Testing in the United States .................................................................. 8
Design of Stress Testing in the European Union ............................................................ 10
Outcomes and Implications of the Latest Stress Testing .................................................... 11

Criticism .............................................................................................................................. 18
Conclusions ........................................................................................................................ 20
Works Cited ........................................................................................................................ 22
Additional Tables and Illustrations ...................................................................................... 26
List of Tables
Table 1. Summary of 2015 DFAST and CCAR testing scopes (Ernst & Young
LLP, 2015) ..................................................................................................................... 11
Table 2. Comparison of elements of microprudential and macroprudential stress
tests (Greenlaw, Kashyap, Schoenholz, & Shin, 2012) ................................................. 26
Table 3. List of the banks which passed/failed the stress tests (Neretina, Sahin, &
de Haan, 2014) .............................................................................................................. 26
Table 4. List of all global SIFIs, as of Nov. 2014 (Financial Stability Board, 2014)
...................................................................................................................................... 27
Table 5. List of domestic SIFIs in the USA as of March 2014 (Board of Governors
of the Federal Reserve System, 2014) .......................................................................... 29
Table 6. Comparison of Dodd-Frank Stress Tests for Large and Mid-Size Banking
Organizations (Fei, 2014) .............................................................................................. 30
List of Figures
Figure 1. CCAR 2015 results for the major BHCs in the US (Deloitte Center for
Regulatory Strategies, 2015) ......................................................................................... 13
Figure 2. Overview of EU Stress Testing Outcomes in 2010-2014 (Steinhauser,
Enrich, & Colchester, 2014) ........................................................................................... 14
Figure 3. Sources of capital raised by the EU banks in Jan-Oct, 2014, EURbn
(Steinhauser, Enrich, & Colchester, 2014) .................................................................... 15
Figure 4. Breakdown of European banks' capital raising, by country, since July
2013, based on Morgan Stanley data (Steinhauser, Enrich, & Colchester, 2014) ......... 15
Figure 5. Breakdown of individual bank capital shortfall as of Oct. 2014 (Karaian,
2014) ............................................................................................................................. 16
Figure 6. Capital shortfall as of Oct. 2014 by countries, EURmln (Steinhauser,
Enrich, & Colchester, 2014) ........................................................................................... 17
Figure 7. Monthly outstanding loans to non-financial sector and year-to-year
growth rates in the Euro-zone, Jan 2007 Mar 2015, seasonally adjusted (European
Central Bank, 2015) ....................................................................................................... 17

Figure 8. Quarterly GDP and year-to-year growth rates in the Euro-zone, Q12007 Q4-2014, at constant prices, seasonally adjusted (European Central Bank, 2015)
...................................................................................................................................... 18
Table of Abbreviations
AFMn Autoriteit Financile Markten (the Netherlands)
AMF Autorit des marchs financiers (France)
AQR Asset Quality Review
BaFin Bundesanstalt fr Finanzdienstleistungsaufsicht (Germany)
BdE Banco de Espaa (Spain)
BHC bank holding company
bn billion
CBRC China Banking Regulatory Commission
CCAR Comprehensive Capital Analysis and Review
CONSOB Commissione Nazionale per le Societ e la Borsa (Italy)
DFAST Dodd-Frank Act Stress Testing
EBA European Banking Association
ECB European Central Bank
EU European Union
EUR Euro
Fed Federal Reserve Bank
FINMA Financial Market Supervisory Authority (Switzerland)
FSA Financial Services Authority (UK)
FSAj Financial Services Agency (Japan)
FSMA Financial Services and Markets Authority (Belgium)
FSOC Financial Stability Oversight Council (USA)
G-SIB global systemically important banks
mln million
PPNR Pre-Provision Net Revenue
5

SCAP Supervisory Capital Assessment Program
SFAs Finansinspektionen (Sweden)
SIFI systemically important financial institution
USA, US United States of America
USD US dollar

This financial crisis was due to opacity and lack
of transparency in financial markets and regulators who were asleep at the wheel. But now the
administration and the regulators have decided
to add liberally to the fog of opacity. Why call
them stress tests? Fudge tests would be a
truer description. Nouriel Roubini (2009)
Stress testing is a risk management tool nowadays regularly used by national

banking and financial regulators to assess the capacity of the largest bank holding companies ability to weather financial and economic market turmoil and find out if they possess sufficient capital buffers to continue operations throughout such adverse periods.
Such testing also tries to see if the BHCs have robust, forward-looking capital-planning
processes that account for their unique risks. (Board of Governors of the Federal
Reserve System, 2014)
Capital adequacy ratios as a tool used in prudential bank regulation have been
used prior to the adoption of the first Basel Accords in 1988. Conversely, stress-testing
has a shorter history and historically was predominantly used in-house within banking
and financial institution as one of diverse array of risk management tools. In 2009, the
stress-testing techniques were introduced to system-wide risk management toolkit by
financial regulators in the US and EU. (Wall, 2014)
Stress Testing in Europe and the US: Overview

National bank supervision agencies expect banks to hold sufficient capital to cover losses should adverse economic conditions occur. In this area, stress testing has become one of the most important tools for bank supervisors to achieve that goal.
Greenlaw et al. (2012) distinguish two types of stress tests: microprudential and
macroprudential. Microprudential stress tests focus on preventing bank failures that result after bank equity meltdown. Here, bank capital is viewed as a buffer against losses
that takes hit before the deposit insurance agency gets hold of situation. Stress testing
procedures focus on Basel capital ratios, and stability and liquidity crises are motivating
7

events. At the same time, macroprudential stress tests view the banking system as integrated unit where entire balance sheet capacity of BHCs supports the normal functioning of the wider economy. Per Greenlaw et al. (2012), the central goal of the testing is to
prevent or mitigate consequences of bank runs on system critical institutions by wholesale creditors, which might lead to loan volume contraction and damage to the broader
economy. According to the authors, results should include specific money amounts of
capital that should be raised rather than focus on mere satisfaction of capital ratios. The
summary of differences microprudential and macroprudential stress testing techniques
can be found in Table 2 in Additional Tables and Illustrations.
Another way that stress-testing designs may differ one from the other is their objectives, i.e. whether their results are intended for internal or external use. Stress testing
that is performed for internal decision making purposes are used to reflect the risk management culture of the organization. On the other hand, the results of the stress testing
exercise that are meant to be used externally should be well understood by the target
audience, i.e. regulators, authorities, investors and consumers. (Drehmann, 2008)
European and American regulators are pursuing similar goals when they conduct
stress testing of major BHCs, namely understanding their capacities to absorb financial
losses and through these preventing financial disturbances from negatively affecting activities of other actors in a broader economy. At the same time, their approaches to the
stress testing process, design of such testing exercises and subsequently their focus
differ in each case.
Design of Stress Testing in the United States
In 2009, when the first stress tests were conducted in the US, the Fed had not
adopted Basel II as a framework in bank supervision. Therefore, between 2009 and
2014, the Fed was using a combination of Basel I with its amendments and a leverage
ratio with gross total assets in the denominator. Current stress testing procedure was
adopted due to the requirements of the Basel III which was adopted by the US bank supervisor for the implementation in 2014 (Wall, 2014).
Nowadays, the US Federal Reserve is committed to using two measures to assess capital adequacy and the degree of financial stability of the BHCs under its supervision. The Dodd-Frank Act introduced annual Dodd-Frank Act Stress Testing which
8

was meant to restore confidence in the US banking system in 2009 and is the scenariobased stress testing exercise in the US. (Board of Governors of the Federal Reserve
System, 2014)
The scenarios are divided into base, adverse and severely adverse depending on the underlying projections. The base scenario aligns with general economic
forecasts for the US economic development throughout the testing period; adverse and
severely adverse scenarios are completely hypothetical and are developed purely to
test the rigidity of the banking system to withstand economic shocks (Board of
Governors of the Federal Reserve System, 2014).
The scenarios start in the 4th quarter of 2014 and extend to the 4th quarter of 2017
(i.e. they encompass 12 quarters in total). The set of 28 variables has stayed unchanged
compared to the last year stress-testing describing the economic conditions in the US
and abroad. The internal variables are divided as follows: six measures of economic activity and prices, four aggregate measures of asset prices or financial conditions, and six
measures of interest rates. The international variables are grouped by countries or country blocs (i.e. four such groups) and describe three variables each: real GDP growth,
CPI change, and USD/local currency exchange rate. (Board of Governors of the Federal
Reserve System, 2014)
DFAST, a forward-looking component of the assessment procedures, is conducted by the Fed and financial companies under review. DFAST is used to assess if the
BHCs have enough capital to absorb losses and continue operations without disruptions
during adverse economic conditions while using historical capital actions of each BHC
(i.e. dividends or stock buy-backs). Complimentary to DFAST, Comprehensive Capital
Analysis and Review, an annual exercise, is carried out by the US Fed. According to the
methodology, the Fed analyses capital adequacy ratios, capital assessment processes
implemented by BHCs while taking into account capital action plans proposed by the
BHCs. As of 2014 reporting period, BHCs active in the US with assets less than
USD10bn were not subject to CCAR and DFAST procedures. (Board of Governors of
the Federal Reserve System, 2014). Based on the DFAST and CCAR results the Fed
can demand amending the capital action plans proposed by the bank or even turn them
down altogether. (Ernst & Young LLP, 2015)
9

31 BHCs participated in 2015 DFAST and CCAR (those BHC with assets between USD10bn and USD50bn were required to conduct DFAST only). Deutsche Bank
Trust Corporation is the only new BHC participating in CCAR/DFAST 2015 compared to
2014 stress-testing publication period. Nine participants with aggregate assets exceeding USD50bn each were tested as members of the Large Institution Supervision Coordinating Committee portfolio. These BHCs are Bank of America, BNY Mellon, Citigroup
(Citi), Deutsche Bank Trust Corporation, Goldman Sachs, JPMorgan Chase, Morgan
Stanley, State Street and Wells Fargo. The Fed has heightened expectations for capital
planning processes at these institutions relative to other CCAR participants due to their
size, complexity, and role in the wider economy. (Ernst & Young LLP, 2015) Such expectations translate into requirement to run company-designed stress-testing twice a
year. (De Ghenghi & Rohrkemper, 2015). For more information on how the DFAST
stress-testing approach differs between large and mid-size BHCs, please, refer to Table
6 in Additional Tables and Illustrations.
Design of Stress Testing in the European Union
The results for the latest Euro-zone stress-testing were published in October
2014. During this stress testing exercise, balance sheets of 130 BHCs across 18 countries and Lithuania1 with combined assets amounting to 85% of Euro-zones banking industry aggregate assets were scrutinized by the European Central Bank while national
regulators assisted in the process. At the same time, European Banking Association ran
tests on 123 banks in 28 countries across the EU. Parallel to stress-testing, Asset Quality Review took place to determine the value of the assets on the balance sheets, and it
was conducted by ECB and the national regulators. (Steinhauser, 2014). Within the
AQR, ECB examined 800 portfolios which represented ca. 57% of the banks riskweighted assets. This exercise included analysis of 119,000 borrowers and 170,000
pieces of collateral (Quinn, 2014).
As Steinhauser (2014) describes it, the EU stress-testing and AQR were designed to detect banking institutions which risk weighted assets would fall below 8%
threshold should the economy develop as expected (during the latest stress testing exercise: until 2016). The crisis scenario envisaged a two-year recession combined with a
1
Lithuania was not a member of the Euro-zone at the time of testing but was to join the monetary
bloc as of January 1, 2015
10

market panic as experienced in the US after the collapse of Lehman Brothers. In this
case, the BHCs were to maintain a capital buffer of at least 5.5%.
Should a bank fail the test, within two weeks, its management had to come up
with a plan to increase BHCs capital buffer. The shareholders are incentivized to be one
of the primary sources of new capital; another option is selling excessive or risky assets
on the market. In case a BHC fails either AQR or stress tests baseline scenario, its
management has six months to implement the proposed plan. Those that fail only crisis
scenario are given nine months to increase the capital ratio. In severe cases, i.e. a capital hole is found on Systemically Important Financial Institutions balance sheet, a capital
increase plan is to be developed within one week. If the bank fails to increase its capital
ratio, the government or national agency has to step in, but only after the current shareholders take a haircut. (Steinhauser, 2014)
Outcomes and Implications of the Latest Stress Testing

Stress-testing exercise in the USA was first conducted in 2009 and since then the
exercise was carried out annually, except for 2010 when it did not take place. The summary of the US stress tests in 2009-2013 is shown in Table 3 in Additional Tables and
Illustrations.
Latest DFAST and CCAR results were published on March 5, 2015, and March
11, 2015, respectively. The summary of what the scopes of 2015 DFAST and CCAR exercises is presented in Table 1 below:
Table 1. Summary of 2015 DFAST and CCAR testing scopes (Ernst & Young LLP,
2015)
DFAST 2015
CCAR 2015
Supervisory run
Company run
Supervisory run
Coverage
31 BHCs
31 BHCs
31 BHCs
Conducted by
Fed
BHC
Fed
Models used
Fed
BHC
Fed
Capital actions assumed
Standardized per DFAST rules

(historical dividends)
Standardized per DFAST rules

(historical dividends)
BHC proposed capital actions
Analysis
Quantitative
Quantitative
Quantitative and qualitative
Public disclosures
Fed discloses summary of

stress test results for supervisory severely adverse and adverse
Each BHC discloses summary

of stress test results for supervisory severely adverse sce-
Objection or non-objection to
BHC capital plans;
Post-stress test capital ratios,
11

DFAST 2015
scenarios
nario
CCAR 2015
incl. planned actions, for severely adverse and adverse
scenarios
Of the 31 banks that underwent the 2015 DFAST and CCAR testing, all institutions successfully passed the scrutiny. The results of both simulation-based DFAST with
historical capital actions and the forward-looking CCAR showed that the lowest Tier 1
Common capital ratios were at the BHCs that have large investment banking and trading
activities (BHCs IB & Retail and Custodian on Figure 1) as the leverage ratios appears to be a binding constraint for these institutions (Ryan, Alix, Gilbert, & Meyer,
2015). At the same time, Ryan et al. (2015) notes that 2015 DFAST results indicated
that on average there is more Tier 1 Capital in the banking system now than it was before the stress-tests were introduced: 8.2% under the severely adverse scenario, which
is higher than the same banks pre-stress T1C average of 5.5% at the beginning of
2009.
Over the DFAST simulation period, total losses at the 31 BHCs under the severely adverse scenario were projected to reach USD490bn. At the same time, projected net
revenue before provisions for loan and lease losses (pre-provision net revenue, PPNR)
was projected to reach USD310bn, and net losses before taxes USD222bn. (Board of
Governors of the Federal Reserve System, 2015)
12

Figure 1. CCAR2 2015 results for the major BHCs in the US (Deloitte Center for
Regulatory Strategies, 2015)
12%
BHC IB & Retail
Credit card
6,0%
7,0%
8,0%
6,4%
7,1%
6,4%
9,5%
6,9%
7,3%
5,4%
7,1%
HSBC North America Holdings Inc
Huntington Bancshares Incorporated
KeyCorp
M&T Bank Corporation
MUFG Americas Holding Corporation
Regions Financial Corporation
Santander Holdings USA. inc.
SunTrust Banks, Inc.
The PNC Financial Services Group, Inc.
Zions Bancorporation
U.S. Bancorp
11,0%
6,8%
8,2%
Deutsche Bank Trust Corporation
5,2%
BMO Financial Corp.
Citizens Financial Group, Inc.
7,8%
5,4%
Custodian
Comerica Incorporated
6,6%
BB&T Corporation
BBVA Compass Bancshares, Inc.
7,2%
Ally Financial Inc.
State Street Corporation
Bank of America Corporation
The Bank of New York Melon 4,8%
6,4%
Northern Trust Corporation
4,3%
9,6%
Discover Financial Services
5,6%
Wells Fargo & Company
6,8%
4,8%
The Goldman Sachs Group, Inc.
7,6%
4,2%
Morgan Stanley
American Express Company
4,1%
JPMorgan Chase & Co.
Capital One Financial Corporation
4,4%
5,0%
Citigroup Inc.
4%
Fifth Third Bancorp
8%
Regional
CCAR Tier 1 Level, %
Minimum Threshold
Ryan et al. (2015) elaborates further on the outcomes of the recent stress testing
exercise in the US noting that total loan losses declined for the third time (to 6.1% down
from 6.9% in 2014 and 7.5% in 2013) which can be attributed to improved underwriting
standards as well as improving situation with the legacy credit portfolios. Additionally,
the banks under review have prepared to the possible Feds rate increase with only four
institutions not showing pre-tax profit over the nine quarters simulation period. Further
on, the authors add that the 2016 DFAST and CCAR will most likely be tougher for the
BHCs under review with Global Systemically Important Bank capital surcharge being ultimately factored into the stress testing process. Such change is driven by the criticism
that the Fed received for being too predictable.
The most recent European stress testing for 2013 published in October 2014 indicated a cumulative capital shortfall of EUR24.6bn (or ca. USD31.2bn). The previous
stress-testing exercises in the Euro-area brought criticism for their lack of rigorousness
and failed to notice holes in capital structure of several banks. This one, however, was
2
Minimum threshold of 4%
13

promised to bring real prudential supervision to the European banking industry. ECB
Executive Board member Joerg Asmussen also admitted that this stress-testing was the
last chance for the ECB to restore confidence in the industry and the ECB itself as its
supervisor. The ECB President Mario Draghi vowed to give failing marks to the BHCs
which would not stand the test. (Riecher & Black, 2013)
Since the test results showed capital deficit as of year beginning, most of it had
been already covered by October, and only EUR9.5bn was still outstanding. Figure 2
below shows how the 2014 results compare to the previously held stress tests in the EU.
The rising number of banks that failed the stress testing is attributed to the growing
number of institutions under scrutiny, on one hand, and to the growing rigorousness of
the test itself, on the other hand. This was done to show different stakeholders that the
financial stability of the European banking system was improving after the first stress
tests failed to take note of the upcoming difficulties at some of the institutions
(Steinhauser, Enrich, & Colchester, 2014). More on this issue will be presented in chapter Criticism below.
Figure 2. Overview3 of EU Stress Testing Outcomes in 2010-2014 (Steinhauser,
Enrich, & Colchester, 2014)
92,3%
30
100%
83,3%
77,8%
25
15
EUR26,8bn
10
50%
25
EUR24,6bn
20
Pass ratio
No.; EURbn
75%
20
25%
5
EUR3,5bn
0%
2010
No. of banks that failed
2011
2014
Overall capital shortfall, EURbn
Pass ratio
Of the 25 failed banks, 12 institutions increased their capital buffers by the reports publication date. Most of the capital (EUR25.9bn or ca. 73%) increase came in
form of new equity, according to data from Morgan Stanley (Steinhauser, Enrich, &
Colchester, 2014):
Capital shortfall does not take into account funds raised since Jan. 1, 2014
14

Figure 3. Sources of capital raised by the EU banks in Jan-Oct, 2014, EURbn
(Steinhauser, Enrich, & Colchester, 2014)
Trading gains
from
unwinding
carry
3,7
10%
IPOs/
divestments
6.0
17%
Equity
issuance
25,9
73%
The distribution of BHCs that failed the test aligns with the countries that were
most affected by the aftermaths of sovereign debt crisis in the EU, i.e. most of such institutions were in Italy, Greece, Spain, Portugal, and Ireland, although presumably stronger
northern countries such as Ireland, Belgium, Germany, and Austria also saw some of
the failed banks. Given this, most of the capital raising took place in southern EU:
Figure 4. Breakdown of European banks' capital raising, by country, since July
20134, based on Morgan Stanley data (Steinhauser, Enrich, & Colchester, 2014)
Since banks started responding to the ECBs AQR
15

Among the 13 banks that had not increased their capital buffer by the stresstesting reports publication date, the biggest problems were found with Italian, Greek and
Portuguese banks. Among the BHCs with uncovered holes in their capital structure was
Banca Monte dei Paschi which is Italys third-largest and has to come up with EUR2.1bn
of capital representing ca. 63.7% of all capital shortfall by the Italian lender as of October 2014. As for the Greek banks, Eurobank and National Bank of Greece although
failed, had no or practically no shortfalls taking into account capital already raised, the
ECB said. Dexia SA, which needed government bailout5 after the 2011 stress testing indicated it had enough capital, is being wound down according to the plan approved by
the EU authorities in 2012 (Leighton-Jones & Hearon, 2014). For more details on the
capital needs exposed by the stress-testing outcome, please refer to Figure 5 and Figure 6 below:
Figure 5. Breakdown of individual bank capital shortfall as of Oct. 2014 (Karaian,
2014)
500
1 000
1 500
2 000
Banca Monte dei Paschi di Siena
2 500
2 110
Eurobank
1 760
Banco Comercial Portugues
1 150
National Bank of Greece
930
Volksbank
860
Permanent TBS
850
Banca Carige
810
Dexia
340
Banca Popolare di Vicenza
220
Hellenic Bank
180
Banca Popolare di Milano
170
Nova Kreditna Banka Maribor
30
Nova Ljubljanska Bank
30
Capital shortfall, EURmln
Under the restructuring plan, the BHC received EUR90bn of government guarantees from the
French, Luxemburg, and Belgian governments, the Belgian and French governments provided EUR6bn of
public bailout funds; later in 2011 Belfius received another EUR4bn financial assistance from the Belgian
government. It was split into two separate institutions of which Belgium-based resumed its banking operations under the new name Belfius, and the Netherlands-based part of the BHC was set up as a bad
bank (Treanor, 2011)
16

Figure 6. Capital shortfall as of Oct. 2014 by countries, EURmln (Steinhauser,
Enrich, & Colchester, 2014)
Portugal; 1
150
Austria;
860
Greece; 2
690
Ireland;
850
Belgium;
340
Italy; 3 310
Cyprus;
180
Slovenia;
60
Whether the latest EU stress-testing was a success and brought back trust to the
banking industry in the Euro-zone, remains disputable. It should be noted, however that
the volumes of bank lending growth rates in the Euro-zone increased after the publication of the stress-testing results as indicated in Figure 7:
Figure 7. Monthly outstanding loans 6 to non-financial sector and year-to-year
growth rates in the Euro-zone, Jan 2007 Mar 2015, seasonally adjusted
16,0%
12 000 000
8,0%
EURmln
18 000 000
6 000 000
Dark grey bars represent the months of publication of bank stress testing results
17
Jan-15
Jul-14
Y-to-Y %-change
Oct-14
Apr-14
Jan-14
Jul-13
Oct-13
Apr-13
Jan-13
Jul-12
Oct-12
Apr-12
Jan-12
Jul-11
Outstanding loans, EURmln
Oct-11
Apr-11
Jan-11
Jul-10
Oct-10
Apr-10
Jan-10
Jul-09
Oct-09
Apr-09
Jan-09
Jul-08
Oct-08
Apr-08
Jan-08
Jul-07
Oct-07
Apr-07
Jan-07
(8,0%)
Y-to-Y %-change
(European Central Bank, 2015)

At the same moment, this growth may due to be economic stabilization of the
GDP growth in the Euro-zone: according to the ECBs data, after the 1 st quarter 2013
the risk of W-shaped recession in the Euro-zone diminished as the growth rate picked
up from the anemic rates around 0% in 2012, as depicted in Figure 8. Given lending
volumes react to GDP growth rates with some time lag, such GDP dynamics could significantly contribute to general situation in the banking sector.
Figure 8. Quarterly GDP and year-to-year growth rates in the Euro-zone, Q1-2007
Q4-2014, at constant prices, seasonally adjusted (European Central Bank, 2015)
3 000 000
8,0%
4,0%
2 500 000
2,0%
(2,0%)
2 250 000
(4,0%)
Y-to-Y %-change
EURmln
6,0%
2 750 000
(6,0%)
Eurozone GDP, EURmln
Q4-2014
Q3-2014
Q2-2014
Q1-2014
Q4-2013
Q3-2013
Q2-2013
Q1-2013
Q4-2012
Q3-2012
Q2-2012
Q1-2012
Q4-2011
Q3-2011
Q2-2011
Q1-2011
Q4-2010
Q3-2010
Q2-2010
Q1-2010
Q4-2009
Q3-2009
Q2-2009
Q1-2009
Q4-2008
Q3-2008
Q2-2008
Q1-2008
Q4-2007
Q3-2007
Q2-2007
(8,0%)
Q1-2007
2 000 000
Y-to-Y %-change
Criticism
The observers, industry experts, and analysts have been vocal about the shortcomings of the stress-testing exercises both in the US and the EU since the financial
check-ups were introduced in 2009, with most criticism addressing the EU stress tests
due to their unreliable results in the past. (Hardy & Hesse, 2013)
Kashyan et al. (2012) argue that stress testing exercises both in the US and the
EU fail to determine the rigidity of the whole banking system to weather sudden economic and financial downturns as they concentrate on balance sheets of individual
banks in isolation while ignoring potential spillover effects within the whole system. The
authors go ahead to note, that banking regulators during stress testing concentrate on
the common capital levels while they ignore the main source of balance sheet financing
being wholesale bank financing. Compared to common equity, wholesale financing is
more volatile and can be withdrawn by the creditors should they sense increasing market risks forcing banking institutions to fire sell their assets to deleverage balance
18

sheets, and consequently leading to domino effect as asset prices decline which affects
all market players.
Goldstein (2014) suggests that the ECB and EBA scrap the risk-weighted assets
as a base measure used in stress testing since it proved to be a less predictable measure of bank failure in the future. Unweighted leverage ratios are already used in the US
and the UK bank stress testing and have proved their usefulness. Furthermore, before
the 2007-2009 financial crisis, risk weighted measures indicated that banks were wellcapitalized in contrast to the unweighted measures. However, at the same time, Goldstein stresses that EU regulators should not completely rely on the US approach to
stress testing and the requirements that the Fed has developed for the BHCs under its
supervision: the EU banking system is more concentrated than the US one, and therefore European banks need to hold higher capital cushions compared to their US counterparts.
Some observers have also criticized accounting tricks that the BHCs employ to
hide the magnitude of their risk exposure. There is a significant room for balance sheet
optimization according to Alberto Gallo, head of European macro credits at Royal Bank
of Scotland, and the bigger the BHC the better it can conceal risky assets (Thompson
& Ross, 2014). Alberto Gallo adds further: There is almost an inverse relationship between the size of banks and how much regulatory risk they declare some large investment banks have optimized their models over time to show their assets are less
risky. For example, Deutsche Bank in its 2012 annual financial report has managed to
present EUR55.605 trillion of derivative exposure7 via first displaying net values on assets side amounting to EUR776.7bn and on liabilities side to EUR756.4bn, which in the
end netted each other to the amount of EUR20.3bn. (Durden, At $72.8 Trillion,
Presenting The Bank With The Biggest Derivative Exposure In The World (Hint: Not
JPMorgan), 2013)
Another point of criticism is the how the results of stress testing are used by the
BHCs shareholders. Should a given bank pass the test, such result effectively allows
distribution of dividends regardless of how much better than the threshold were the re7
The aggregate deposits of the Deutsche Bank are ca. 100 times smaller, and this amount is ca.
20 times larger than the entire 2012 GDP of Germany, as Germany Trade & Invest indicates (Business
Briefing: Germany, 2014)
19

sults. For example, in 2007 the US supervisors allowed distribution of dividends amounting to USD80bn by 19 banks which in 2009 were subject to Supervisory Capital Assessment Program. This amounted roughly to half of the total public funds injected in
these institutions in the form of recapitalization later. (Greenlaw, Kashyap, Schoenholz,
& Shin, 2012)
Last but not the least important point of criticism is the stress-testing scenarios
which in some respects envisage mild or short-living recessions. For example, the ECB
did not include deflation in its set of scenarios even though the Euro-zone was about to
be in deflation according to statistical data (Durden, 2014). The Feds 2014 DFAST scenarios envisaged relatively swift return to economic growth as well as Dow-Jones Industrial Index returning to record high levels within 9 quarters (Durden, 2015).
Conclusions
In this paper, I tried to outline the way stress testing as regulatory risk management and prudential tool has been implemented in the US and the Euro-zone. Although,
both approaches have much in common, there are important differences between the
two. There is also a lot to improve in both stress-testing methodologies, if the regulators
are determined to make stress-testing an effective tool in a macroprudential supervisory
arsenal. Currently, due to various reasons most improvements are to be developed and
implemented by the ECB, the EBA, and the newly set-up Single Supervisory Mechanism
and European Systemic Risk Board which together will coordinate and conduct banking
stress testing in the EU.
The evolution of the stress testing throughout the past years revealed several
weak points that should be addressed in the near future. Some of the major points have
been covered in the section Criticism of this paper. At the same time, as forward-looking
prudential exercise, the future generations of the stress testing should seek to address
not only issues that ignited the 2007-2009 financial crisis, but also the challenges that
will shape the development of the banking industry in the future.
First off, the regulators have to re-assess the required minimum capital to be
maintained by the banking institutions. As Goldstein (2014) suggests, the required capitalization levels everywhere are too low. He further refers to the broad support by the
20

leading financial academics who propose that the new level of leverage ratios should be
15% which is substantially higher than the 3% proposed by the Basel lll; achieving such
a target would generate substantial social benefits with minimal social cost.
In the midterm, the bank regulators should re-focus their attention on liquidity and
funding stress testing, especially in the context of the phasing in of detailed common reporting templates on maturity mismatches, cost of funding, and asset encumbrance
(Hardy & Hesse, 2013). Future stress-testing scenarios should also incorporate more
long-term factors and generate lessons that relate more to structural issues. The worlds
financial system faces a prolonged period of low interest rates, possibly low growth, increased regulatory burdens under Basel III and in Europe also Capital Requirement Directive IV, demographic change as well as structural changes in employment patterns
(i.e. higher share of part-time, temporary and freelance workers) in developed countries.
These developments will put pressure on profitability, the supply of savings, industry
competition, etc. Therefore, the stress test scenarios need to encompass a longer time
horizon, incorporate structural shifts (e.g. ongoing deleveraging and changes of bank
funding profiles) affecting the balance sheet and income. (Hardy & Hesse, 2013)
21
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Ryan, D., Alix, M., Gilbert, A., & Meyer, A. (2015). Ten key points from the
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25
Additional Tables and Illustrations

Table 2. Comparison of elements of microprudential and macroprudential stress tests (Greenlaw, Kashyap,
Schoenholz, & Shin, 2012)
Item of comparison
Purpose
Microprudential
Macroprudential
The goal is to value bank assets correctly and determine that adequate
The goal is to limit the likelihood and costs of aggregate fire sales, credit
loss-bearing capacity is in place to protect taxpayers from having to bail
crunches and defaults
out insured deposits

Scope
Analyze one bank at a time, or use data from multiple banks to over-
The test examines the entire financial system. Any entity that contrib-
come imperfect information about the value of individual bank assets
utes to fire sales, whose default has follow-on effects, or which can
exacerbate a credit crunch should be included
Liability Considerations
Asset Considerations
Count the amount of insured deposits and the amount of junior debt
Because a run can lead to a credit crunch or fire sale, the scale of
and equity. The required loss absorbency is calculated as a ratio rela-
wholesale funding that is run-prone is paramount. Capital adequacy
tive to asset risk.
depends on the health of the overall financial system
Credit risk of different assets determines enterprise risk, so loss absor-
Asset liquidity is critical, because illiquid assets can contribute to fire
bency of liabilities is tied to asset composition. A capital ratio therefore
sales. Asset risk depends both on default risk and fire sale risk
naturally emerges as a basis for supervision

Output
Develop guidance about whether to close a bank and when to sell its
The test indicates whether the financial system is vulnerable to delever-
assets to maximize taxpayer recovery
aging that might amplify adverse shocks
Table 3. List of the banks which passed/failed the stress tests (Neretina, Sahin, & de Haan, 2014)
Ally Financial
2013
DFAST
-
American Express
Bank of America
Bank of New York Mellon
Bank Holding Companies
2009
2012
26
2013
CCAR
-
US SIFI status in 2014

d

BB&T
Capital One Financial
Citigroup
Fifth Third Bank
Goldman Sachs
JPMorgan Chase
KeyCorp
MetLife
n.a.
n.a.
Morgan Stanley
PNC Financial Services
Regions Financial
State Street
SunTrust Banks
U.S. Bancorp
Wells Fargo
Total assessed BHCs
19
19
18
18
No. of failed BHC
10
47.4%
78.9%
94.4%
72.2%
Pass rate
Notes: This table presents the list of the banks which passed/failed the 2009-2013 stress tests. + means that a bank passed the stress test without any frictions (No-Gap banks), and - indicates that a bank had a capital gap or did not receive approval for capital distributions (Gap banks). n.a. denotes that the bank did not participate in the corresponding testing procedure.
g/d denotes that the bank is a global/domestic SIFI according to the Financial Stability Board (FSB, 2013).
Table 4. List of all global SIFIs, as of Nov. 2014 (Financial Stability Board, 2014)
Entity
Region
HQ country
HQ currency
HQ regulator
Major exchange(s)
Mizuho FG
Asia
Japan
Yen
FSAj
TYO, NYSE
Sumitomo Mitsui
Asia
Japan
Yen
FSAj
TYO, NYSE
Mitsubishi UFJ FG
Asia
Japan
Yen
FSAj
TYO
Bank of China
Asia
China
Renminbi
CBRC
SEHK, SSE
Majority state owned
ICBC
Asia
China
Renminbi
CBRC
SEHK, SSE
Agricultural Bank of China
Asia
China
Renminbi
CBRC
SEHK, SSE
Dexia Group
Europe
Belgium
Euro
FSMA
Euronext
Resolution was ordered Oct 2011. Dexia Bel-
27
Notes

gium was bought out from the group by the
Belgian state, and continues to exist as
Belfius. Remaining part of the group was left
in a "bad bank" to be liquidated.
BNP Paribas
Europe
France
Euro
AMF
Euronext
Crdit Agricole
Europe
France
Euro
AMF
Euronext
Banque Populaire CE
Europe
France
Euro
AMF
cooperative
Socit Gnrale
Europe
France
Euro
AMF
Euronext
Commerzbank
Europe
Germany
Euro
BaFin
XETRA, FWB
Deutsche Bank
Europe
Germany
Euro
BaFin
FWB, NYSE
Unicredit Group
Europe
Italy
Euro
CONSOB
BIT, FWB
ING Bank
Europe
Netherlands
Euro
AFMn
Euronext, NYSE
Banco Bilbao Vizcaya Argentaria
Europe
Spain
Euro
BdE
BMAD, NYSE
Santander
Europe
Spain
Euro
BdE
BMAD, LSE, NYSE
Nordea
Europe
Sweden
Swedish Krona
SFAs
OMX
Credit Suisse
Europe
Switzerland
Swiss franc
FINMA
SIX, NYSE
UBS
Europe
Switzerland
Swiss franc
FINMA
SIX, NYSE
Royal Bank of Scotland
Europe
United Kingdom
British pound
FSA
LSE, NYSE
Barclays
Europe
United Kingdom
British pound
FSA
LSE, NYSE
HSBC
Europe
United Kingdom
USD
FSA
LSE, NYSE, Euronext, SEHK
Lloyds Banking Group
Europe
United Kingdom
British pound
FSA
LSE, NYSE
Standard Chartered
Europe
United Kingdom
British pound
FSA
LSE, SSE, NSE
Bank of America
Americas
USA
USD
FSOC
NYSE
Bank of New York Mellon
Americas
USA
USD
FSOC
NYSE
Citigroup
Americas
USA
USD
FSOC
NYSE
Goldman Sachs
Americas
USA
USD
FSOC
NYSE
JP Morgan Chase
Americas
USA
USD
FSOC
NYSE
Morgan Stanley
Americas
USA
USD
FSOC
NYSE
State Street
Americas
USA
USD
FSOC
NYSE
Wells Fargo
Americas
USA
USD
FSOC
NYSE, BMV, FWB
28
Of declining systemic importance
Of declining systemic importance

Table 5. List of domestic SIFIs in the USA as of March 2014 (Board of Governors of the Federal Reserve System, 2014)
Entity
Region
HQ country
HQ currency
HQ regulator
Major exchange(s)
Notes
Ally Financial
Americas
USA
USD
FSOC
Non-public
Previously owned by GMAC, now 73% owned by

the US government
American Express
Americas
USA
USD
FSOC
NYSE
BB&T
Americas
USA
USD
FSOC
NYSE
BBVA Compass
Americas
USA
USD
FSOC
Subsidiary
Subsidiary of BBVA
BMO Financial Corp.
Americas
USA
USD
FSOC
Subsidiary
Subsidiary of Bank of Montreal
Capital One Financial
Americas
USA
USD
FSOC
NYSE
Comerica
Americas
USA
USD
FSOC
NYSE
Discover Financial Services
Americas
USA
USD
FSOC
NYSE
Fifth Third Bank
Americas
USA
USD
FSOC
NASDAQ
HSBC North America Holdings
Americas
USA
USD
FSOC
Subsidiary
Huntington Bancshares
Americas
USA
USD
FSOC
NASDAQ
KeyCorp
Americas
USA
USD
FSOC
NYSE
M&T Bank
Americas
USA
USD
FSOC
NYSE
MetLife
Americas
USA
USD
FSOC
NYSE
Northern Trust
Americas
USA
USD
FSOC
NASDAQ
PNC Financial Services
Americas
USA
USD
FSOC
NYSE
RBS Citizens Financial Group
Americas
USA
USD
FSOC
Subsidiary
Regions Financial
Americas
USA
USD
FSOC
NYSE
Santander Holdings USA
Americas
USA
USD
FSOC
NYSE / Subsidiary
SunTrust Banks
Americas
USA
USD
FSOC
NYSE
U.S. Bancorp
Americas
USA
USD
FSOC
NYSE
UnionBanCal
Americas
USA
USD
FSOC
Subsidiary
Zions
Americas
USA
USD
FSOC
NYSE, NASDAQ
29
Subsidiary of HSBC Holdings
MetLife Bank failed the stress test in 2012, and

as a consequence sold its banking unit to GE
Capital and its USD70bn mortgage servicing
business to JPMorgan Chase
Subsidiary of Royal Bank of Scotland
Subsidiary of Santander Group
Subsidiary of Mitsubishi UFJ FG

Table 6. Comparison of Dodd-Frank Stress Tests for Large and Mid-Size Banking Organizations (Fei, 2014)
Large BHCs
($50 billion in total consolidated assets)
Mid-size BHCs
(>$10 billion and < $50 billion in total consolidated assets)
General Stress Testing Requirements
Large bank holding companies (BHCs) must participate in Federal Reserves annual Comprehensive Capital Analysis and Review (CCAR) exercise
Mid-size BHCs do not participate in CCAR
Large BHCs are subject to annual supervisory stress tests:
Mid-size BHCs are not subject to supervisory stress tests
Federal Reserve publicly discloses summary results of supervisory stress tests

Mid-size BHCs are not subject to Federal Reserves capital plan rule:
Large BHCs must submit annual capital plans to Federal Reserve:

-
Subject to Federal Reserve approval of results, capital plan and capital actions
No required minimum post-stress capital ratios
Must maintain > 5% post-stress Tier 1 Common ratio
No formal supervisory approval associated with stress testing
Must use both supervisory and BHC-specific stress test scenarios
Only required to use supervisory scenarios in Dodd-Frank company-run stress tests
Dodd-Frank company-run stress test:

-
Semi-annual submissions by January 5th and July 5th of each year
Annual submission by March 31st of each year
Report on form FR Y-14A
Report on form FR Y-16
Semi-annual public disclosures of summary results (March and September)
Annual public disclosure of summary results beginning in June 2015
Incorporation of U.S. Basel III into stress testing:

-
Must incorporate U.S. Basel III capital framework in capital projections
Tier 1 Common ratio is calculated using existing capital rules
Not required to incorporate U.S. Basel III capital framework in capital projections until
the 2015 stress testing cycle starting in October 2014
Not required to calculate Tier 1 Common ratio for 2014 stress testing cycle
Dodd-Frank Stress Test Reporting Requirements

Form FR Y-14A for large BHCs:
Form FR Y-16 for mid-size BHCs, state member banks (SMBs) and savings and loan holding
companies (SLHCs):
Annual and semi-annual (mid-cycle) submission
Annual submission
Approximately 2,500 line items per scenario for annual and 1,900 for semi-annual
(mid-cycle) submission
Summary report with approximately 100 line items per scenario
30

FR Y-14Q for supervisory stress test:
-
Quarterly submission
Loan-level data collected
Not applicable
FR Y-14M for supervisory stress test:

-
Monthly submission
Loan-level data collected
Not applicable
Federal Reserves Minimum Supervisory Expectations for Dodd-Frank Stress Tests

Stress test scenarios:
-
Large BHCs must develop BHC-specific scenarios to stress key vulnerabilities and
identify idiosyncratic risk drivers
Not required to develop own scenarios
Data sources and segmentation:

-
Proxy data acceptable, but generally expected to use internally generated data
May use industry data as a proxy under certain conditions
Data segmented at least as detailed as FR Y-14A (approximately 2,500 lines per scenario)
Data segmented by FR Y-16 (approximately 100 lines per scenario) and largely reflects Call Report and FR Y-9C report
Loss estimation:
-
Identify key loss drivers; indicate how the scenarios affect those drivers and losses
More granular loss estimation expectations using FR Y-14A segmentation
May choose to base their stress losses on industry historical loss experience
May be able to estimate credit losses on an aggregate level (top-down approach) using FR Y-16 segmentation
Operational losses:
-
Expected to include operational loss estimates
Include aggregate operational losses in Pre-Provision Net Revenue (PPNR) only if directly related to macroeconomic and financial scenarios provided by supervisors
Pre-Provision Net Revenue (PPNR) Model:

-
Granular estimation approach
Less granular top of the house approach
Use internal revenue and expense data to estimate business lines revenues and expenses
Project PPNR based on three main components (net interest income, noninterest income and noninterest expense)
Identify specific drivers of revenue and expenses and analyze how supervisory scenarios affect those drivers
Can project at an aggregate, company-wide level, and may be based on industry experience
31

Balance sheet and risk-weighted assets:
-
Projections for each major segment of the balance sheet for FR Y-14A
In some cases, may use a simple, constant method for projecting full balance sheet
and risk weighted assets
Controls, oversight and documentation:

Must be an integral part of preparing and submitting capital plan and the resolution and recovery planning process
Must consider the role of stress testing results in the normal course of business (e.g., capital
planning, assessment of capital adequacy and risk management)
32

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Department of Economics

Faculty of Economics and Behavioral Sciences

Prof. Dr. Martin Goetz

Stress Testing: History of Stress-testing

Ivan Dyachok, 3352663

Outcomes and Implications of the Latest Stress Testing .................................................... 11

Ivan Dyachok, 3352663

Ivan Dyachok, 3352663

Ivan Dyachok, 3352663

Ivan Dyachok, 3352663

Ivan Dyachok, 3352663

Stress testing is a risk management tool nowadays regularly used by national

Stress Testing in Europe and the US: Overview

Ivan Dyachok, 3352663

Ivan Dyachok, 3352663

Ivan Dyachok, 3352663

Ivan Dyachok, 3352663

Outcomes and Implications of the Latest Stress Testing

Capital actions assumed

Standardized per DFAST rules

Standardized per DFAST rules

BHC proposed capital actions

Quantitative and qualitative

Fed discloses summary of

Each BHC discloses summary

Ivan Dyachok, 3352663

Ivan Dyachok, 3352663

BHC IB & Retail

HSBC North America Holdings Inc

Huntington Bancshares Incorporated

M&T Bank Corporation

MUFG Americas Holding Corporation

Regions Financial Corporation

Santander Holdings USA. inc.

SunTrust Banks, Inc.

The PNC Financial Services Group, Inc.

Deutsche Bank Trust Corporation

Citizens Financial Group, Inc.

BBVA Compass Bancshares, Inc.

State Street Corporation

Bank of America Corporation

The Bank of New York Melon 4,8%

American Express Company

Capital One Financial Corporation

Fifth Third Bancorp

CCAR Tier 1 Level, %

Ivan Dyachok, 3352663

Overall capital shortfall, EURbn

Ivan Dyachok, 3352663

Since banks started responding to the ECBs AQR

Ivan Dyachok, 3352663

Banca Monte dei Paschi di Siena

Banco Comercial Portugues

National Bank of Greece

Banca Popolare di Vicenza

Banca Popolare di Milano

Nova Kreditna Banka Maribor

Nova Ljubljanska Bank

Capital shortfall, EURmln

Ivan Dyachok, 3352663

Outstanding loans, EURmln

(European Central Bank, 2015)

Ivan Dyachok, 3352663

Eurozone GDP, EURmln