Lessons learned from EU risk reporting
The European economy has been facing difficult times since the 2008 financial crisis. According to the Wall Street Journal, many economists believe it was partially due to banks' hesitation to lend, compounded by companies holding back required investments.
More recently, stress testing by the European Central Bank (ECB) has created a lot of buzz and worry among investors and the European economy—and perhaps rightly so. According to the 2014 EU-wide stress test report, 24 banks failed their recent stress testing exercise.
The stress testing exercise is designed to reveal the weaknesses of financial institutions. This is done by testing and measuring the adequacy of liquidity, capital management, and corresponding recovery and resolution plans to enhance the strength and safety of the financial system.
The 24 banks that failed their stress tests now face the requirement to increase their capital buffers—either by selling new shares or by divesting assets.
Stress testing in 2010 and 2011 was widely criticized due to computational problems—not to mention the banks that received passing marks required taxpayer bailouts soon after.
The results of this EU-wide stress test have demonstrated that the exercises are working as they should be—accurately assessing financial institutions' resilience to adverse market conditions. With each year, stress testing is becoming more strict, and regulations are being changed to treat tougher stress testing scenarios as benchmarks in order to better determine the overall system risk.
This year the ECB also reviewed the quality of an asset—including mortgages, corporate loans, and all other investments to see whether they're being valued correctly. In coming years, it's expected that testing will become even more challenging for banks.
Ripples in the United States
Similar to how the guidelines in Dodd-Frank were drawn from the recommendations laid out in the 2009 G-20 summit, any harsher regulations looming as a result of this stress testing cycle may trickle down into amendments to Dodd-Frank.
Harsher regulations and more frequent stress testing are a realistic response to these failures from the ECB. And, as history has shown, new regulations in Europe often find their way to the United States.
The bottom line is this—the recent failure of stress testing exercises should serve as a reminder to banks worldwide of how important it is to mitigate risk at all levels throughout the organization.