Banks Asked to Plot Own Collapse in Tests to Find Hidden Risks

  • EBA looks at reverse tests starting with bank's insolvency
  • Tests designed to heighten awareness of risks firm is running

Banks will face tougher requirements in stress tests under guidelines proposed by the European Banking Authority, including identifying scenarios that would bring down their business.

The EBA set out proposed guidelines for stress testing addressed to both banks and supervisors in a paper published late Friday, seeking to draw on lessons it has learned and harmonize procedures across the European Union. The London-based standard-setter for European Union bank supervision recommends using so-called reverse stress tests, which aim to identify weaknesses that could cause a firm to collapse.

“Institutions should use reverse stress testing as a regular risk management tool in order to improve their awareness of current and potential vulnerabilities,” the EBA said. “However, institutions should also consider that the pre-defined outcome of reverse stress testing can be produced by some other circumstances different than the one analysed in the stress test.”

Since the 2008 financial crisis, supervisors have turned to stress testing to identify capital shortfalls that would deplete lenders’ capital reserves, rendering them insolvent and unable to lend. The procedure typically tests banks’ resilience by using a scenario that would wreak havoc on their balance sheets, to understand whether they would be able to withstand it. Supervisory tests run in addition to tests firms conduct internally.

While stress tests typically set out scenarios and examine the outcome, in a reverse test the outcome is pre-defined -- the firm collapses. The aim is to explore “scenarios and circumstances that might cause this to occur,” the EBA said.

The consultation is open until March 18 and the EBA expects to publish final guidelines in the second quarter next year. The guidelines aren’t setting the framework for the exercise for 53 EU banks the EBA is planning next year.

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