European banks face ‘bottleneck’ to complete EBA stress test

New accounting rules and supervisor demands squeeze teams prepping for 2018’s exercise

Lenders across the European Union are struggling with this year’s region-wide stress test as they adjust to new global accounting standards and regulators’ demands for clean and comprehensive data.

“We are just a few people: the credit risk part in the stress test is run by four internal staff and two consultants,” says a senior stress-testing specialist at a mid-sized European bank. “We are not usually staffed for such big changes so it is quite a bottleneck.”

On January 31, the European Banking Authority started its latest biannual stress test assessing the resiliency of banks in the EU through a crisis event. In the test, banks must make projections of the gains and losses, and impact on capital ratios they would face through both a baseline and adverse scenario across three years.

This year’s test is the first to incorporate the new IFRS 9 standard for financial reporting, which came into effect for European banks in January. The accounting regime has piled extra demands on banks’ stress-testing departments as they work to complete the exercise.

“It is true for credit risk this year with IFRS 9 there is more pressure,” says a senior risk manager at a second European bank. “There are a lot of new things to consider and it takes much more time than we expected.”

IFRS 9 radically revamps the way banks assess losses on their assets and the provisions they must hold against those exposures. Instead of recognising losses at the point of impairment, as was the case under the old standard, banks must project losses on all loans regardless of whether or not credit deterioration has occurred.

In determining these “expected credit losses”, banks must assign assets to one of three buckets. Stage 1 assets are those not suffering any credit deterioration. Lenders need only hold provisions against these assets for 12 months of expected losses.

Stage 2 assets are those that have experienced “significant deterioration” in credit risk, while assets are bucketed into stage 3 if they have become fully impaired. In both cases, banks must provision for expected losses over the whole life of the loans, with stage 3 assets also assumed to suffer declining interest revenues.

For some banks, their IT systems have not been allowing them to carry out the calculations in a rapid way and they are taking an enormously long time to run

Kaan Aksel, PwC

To complicate matters further for banks already struggling to adapt to the new standards, the EBA has introduced a variant of stage 2 for the purposes of its stress test. Lenders must now include in this bucket any asset whose lifetime probability of default has increased threefold under either the baseline or adverse scenario, compared with the risk at the point of issuance.

The accounting changes are pushing bank IT systems to their limits, as existing software and architecture must adjust to the complexity of IFRS 9 modelling.

“For some banks, their IT systems have not been allowing them to carry out the calculations in a rapid way and they are taking an enormously long time to run,” says Kaan Aksel, a consultant at PwC based in Frankfurt.

He adds: “It is mainly because the simulations of impairments under IFRS 9 are not fully embedded into banks’ IT systems. They do internal stress testing that can be quickly run but the assumptions and inputs are different for the EBA stress test. The internal stress tests don’t always use IFRS 9 yet, or all the other structural requirements of the EBA stress-testing framework.”

Aksel’s colleague, Radka Margitova, a consultant at PwC based in Frankfurt, says bank IT systems can take between four and 24 hours to run the simulation of one scenario for one year on a portfolio.

Radka Margitova

“It depends on the bank’s portfolio but…if you want to simulate the two scenarios for all three years in the stress horizon for that portfolio, the bank spending 24 hours to calculate the scenario will have to do that over six days,” says Margitova.

With IFRS 9 such a prominent part of this year’s stress test, attention has focused on how banks have organised themselves for the new accounting standard. As well as changing the way banks provision for assets, IFRS 9 also affects the classification of assets on the balance sheet. As such, it affects both the risk and finance divisions of banks.

While some banks chose to have both their risk and finance teams drive their implementation projects, others opted to have one of the two divisions spearhead the project.

As the risk division is responsible for running stress tests, any bank that chose its finance division to lead IFRS 9 implementation would not have had its stress-testing team as closely involved in the development of its new expected credit loss models.

I’m not sure splitting stress-testing teams from the IFRS 9 implementation project is the best way forward

Senior stress-testing manager at a European bank

“I’m not sure splitting stress-testing teams from the IFRS 9 implementation project is the best way forward because usually if you want to stress a methodology then the best people to do that are the people who developed it,” says the senior stress-testing manager at the first European bank. “I have seen a couple of banks in Germany and Sweden who had their projects driven by finance. Our risk and finance teams were involved equally.”

Banks that separated IFRS 9 development from stress testing faced problems, the manager adds: “The stress-testing teams need to learn what IFRS 9 is to stress it.”

Script error

IFRS 9 isn’t the only concern for stress-testing teams as demands for clean data from local supervisors are also a barrier to meeting the final submission date.

Supervisory authorities, including the eurozone’s Single Supervisory Mechanism, the UK’s Prudential Regulation Authority and Sweden’s Finansinspektionen, must submit final results from their banks to the EBA by late October, with the results subsequently published by November 2.

Before supervisors forward their banks’ results to the EBA, firms must pass three cycles of data quality assurance. The first deadline for quality assurance was in early June and the second submission is set for mid-July. The final cycle will take place in late-October. Within those deadlines, the specific submission dates vary according to supervisor.

Our supervisor requires a very high level of precision, so they want to have perfect data

Senior stress-testing manager

In the preliminary submissions, local supervisors assess the data and issue error messages depending on the quality of individual cell data.

“Our supervisor requires a very high level of precision, so they want to have perfect data,” says the senior stress-testing manager. “This is what our major challenge is now before the deadline.”

Those error messages fall into two categories depending on their priority. Errors assigned a higher priority must be resolved by the bank before the next submission date, while those assigned a lower priority should be addressed once the higher priority ones have been resolved.

Banks and consultants refer to the higher priority error messages as “red flags” due to the red mark placed on them in the Excel spreadsheet. Banks have been receiving higher priority error messages in their thousands since submitting their data and must now resolve those before the second submission date.

“It is an ongoing process,” says the senior risk manager at the second bank. “We’ve spent the last two weeks resolving red flags and we are still working on some flags that are not in the higher [priority] group but have to be resolved for the next submission by the end of June.”

Editing by Alex Krohn