Stronger defences needed: stress testing a eurozone break-up

Banks need more capital if they are to survive the worst eurozone scenarios being envisaged by some institutions, say Barry Schachter and Lance Smith

As the financial crisis in Europe deepened over the past 12 months, what had once been unthinkable became the subject of daily speculation: the departure of one or more countries from the euro, joint guarantee of individual sovereign debts, and default by a member of the European Union (EU).

The range of different outcomes is partly a product of the number of actors involved – ranging from the crisis-hit countries and their own domestic political parties to the so-called core governments, the European Central Bank and the International Monetary Fund, all of which have subtly differing fears and priorities. For example, in July last year a second bail-out was agreed for Greece, but before it could be rubber-stamped by various national governments, the then-Greek prime minister, George Papandreou, surprised his peers by announcing the deal would be put to a referendum in his own country. That decision was swiftly reversed and Papandreou’s resignation followed.

In this kind of environment, it becomes difficult to forecast outcomes and impossible to have much confidence in statistical risk measures, so banks and regulators alike have relied increasingly on scenario analysis and stress tests. These are unapologetically subjective tools, so the market moves attached to them vary from one institution to the next.

In recent months, we have discussed stress testing possible eurozone break-up scenarios with several large banks, collecting information about the range and nature of market disruptions envisaged by the industry. The results – outlined in more detail below – were not reassuring. According to our analysis, losses in an extreme scenario would overwhelm bank capital in many cases, suggesting institutions should do more to enhance their defences, however small the chances of the euro fragmenting.

The value of stress tests
When facing a diverse range of outcomes, to which it is difficult to attach accurate probabilities, stress testing comes into its own – and the crisis years have seen it embraced by regulators. In the US, banks are going through their fourth round of Federal Reserve-administered tests – the Dodd-Frank Act requires these to become annual for all banks with $50 billion or more in assets, which are expected to demonstrate capital adequacy in assumed stress conditions. In January, the Federal Deposit Insurance Corporation proposed its own tests on banks with $10 billion and upwards in assets.

Europe’s authorities have carried out their own stress tests on either a national, or pan-European basis. Markets paid close attention on December 8, when the European Banking Authority released its stress test-based capital assessment of EU banks, showing the industry needs to raise $115 billion in new capital. The Dow Jones Eurostoxx 50 dropped 5.8% in the days around the announcement.

Stress testing has grown up alongside another, perhaps better-known, approach to risk measurement, value-at-risk. But the latter has shortcomings that were cruelly exposed during the crisis – VAR estimates the maximum daily loss up to a certain confidence level but offers no insight into potential losses beyond that boundary.

This is where stress testing comes in – it attempts to estimate losses resulting from specific, hypothetical scenarios without necessarily considering probabilities. As a result, market participants today tend to use a mixture of three main analytic approaches to risk measurement.

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