Using stress testing in the policy process – an overview

Prepared by Katarzyna Budnik

This article explores how regulatory stress testing is used in policy processes today, over a decade after it was first advocated as a part of the response to the Global Financial Crisis. It argues that the use of regulatory stress tests has expanded beyond their initial role of assessing the robustness of individual financial institutions. The article reviews the stress testing activities of the European Central Bank (ECB) and discusses how it applies stress testing in examining the propagation of systemic risks stemming from the interconnectedness of banking and non-banking institutions. Furthermore, stress testing is used to set prudential buffers, to evaluate the sufficiency of prudential policies in a timely manner, and to communicate with the industry and markets.

Stress tests assess the ability of financial institutions to withstand adverse economic conditions. Financial institutions are complex enterprises with balance sheets that are difficult for the wider public to read and understand. Stress tests estimate the solvency or liquidity of financial institutions in hypothetical unfavourable macro-financial conditions, such as a deep recession or financial market disturbances. Stress tests are therefore a condensed and easy way to interpret measures of financial resilience. Stress testing evolved from being part of financial institutions’ internal risk management practices to become a standard regulatory tool in the wake of the Global Financial Crisis.

This issue of the Macroprudential Bulletin discusses how stress testing methods have since the Global Financial Crisis been used increasingly and applied in versatile ways in prudential policy processes. The articles look at three applications of stress testing in prudential policy processes: measuring risks in the financial system, calibrating prudential instruments, and communicating with the industry, financial markets and the public. These applications serve both microprudential and macroprudential aims, with stress testing methods being applied regularly to assess “traditional” cyclical risk and to address new challenges, such as climate change. This testifies to the methodological advancements in stress testing methods and their flexibility in terms of being able to adapt them to different policy issues and changing financial systems.

The European framework for stress testing financial institutions dates back to 2011 and the creation of the European System of Financial Supervision. Three European supervisory authorities, namely the European Banking Authority (EBA), the European Securities and Markets Authority (ESMA), and the European Insurance and Occupational Pensions Authority (EIOPA), were asked to perform regular stress tests of the financial institutions under their remit (as well as to establish the corresponding standards for the industry) in close cooperation with the European Systemic Risk Board (ESRB). The EBA was the first to follow up on this mandate by organising the first European Union-wide stress test in 2011, which has been repeated biannually thereafter, with some interruptions. Following the creation of the Single Supervisory Mechanism (SSM) in 2014, the stress testing exercise has been organised jointly by the EBA and the ECB. Since then, the exercise has included more banks, and its role has expanded, with stress test results used to calibrate capital requirements and buffers under Pillar II.^[1]

ECB stress testing methodologies have evolved conjointly with the European regulatory landscape. In 2011 the ECB established a comprehensive methodology for designing macro-financial scenarios for EBA and later ESMA and EIOPA stress tests. It has also developed a rich set of models to scrutinise bottom-up bank submissions through EBA/ECB stress tests. These models provide so-called benchmark parameters for several variables reported by banks. Comparing banks’ submissions against the benchmark parameters and, if need be, challenging them, ensures a level playing field between participating banks and that the overall exercise is sufficiently conservative. Lastly, to support the ESRB in its mission and in delivering on its mandate of macroprudential oversight in the framework of the SSM, the ECB embarked on developing its macro-financial stress testing toolbox.^[2]

The ECB’s macro-financial stress test explores two avenues. The first avenue, i.e. the macroprudential stress test, looks at the interactions between the financial sector and the real economy. Its aim is to develop an approach at the crossroads of stress testing and macroeconomic models (referred to as a workhorse model approach), concentrating on bank heterogeneity identified from stress testing and deriving forecasting abilities and adaptability to different policy issues from macroeconomic models. The second avenue, i.e. the system-wide stress test, gives most prominence to the interconnectedness of, and interactions between, different financial sector segments. It integrates banks, insurers, investment funds and other financial institutions to respond to the growing role of non-bank intermediation in the financial system, while leveraging the models developed for benchmark parameters. Both approaches help in developing an understanding of the emergence and propagation of systemic risks.^[3]

In this issue of the Macroprudential Bulletin, the article by Dubiel-Teleszynski et al. (2022)^[4] applies the ECB’s system-wide stress test to diagnose the financial sector’s ability to withstand climate-related stress. This application returns to the initial aspiration of stress testing to measure financial institutions' soundness. At the same time, it marks the expansion of regulatory stress tests to assess the health of entire financial systems, i.e. financial stability, and their responsiveness to new policy demands such as those related to the climate crisis. The article brings to fore the system-wide nature of climate risks that affect many parts of the financial system at the same time. As such, climate risks are likely to trigger pronounced amplification effects through the financial system. Looking at the banking, insurance and investment fund sectors separately might lead to a falsely reassuring assessment of the materiality of climate risks.

The focus by di Iasio et al. (2022)^[5] provides a complementary view of system-wide amplification effects. It looks at the amplification of shocks to the corporate sector akin to some of those observed at the onset of the COVID-19 pandemic by applying a model encompassing the banking, insurance, pension fund, investment fund and hedge fund sectors. This model explores how different institutions interact and influence equilibrium prices in asset, funding and derivatives markets. 

In their article, Budnik et al. (2022)^[6] focus on applying stress testing methods to assess and calibrating policy tools. The authors showcase how the ECB’s macroprudential stress testing could address prodigious economic uncertainty and factor in the interactions between policies in conducting policy assessments during the COVID-19 pandemic. The maturation of macroprudential stress testing made it possible for the ECB to look at the lending implications of selected regulatory and prudential policies before the pandemic.^[7] However, the multifaceted responses of the supervisory, macroprudential authorities, governments and central banks to the pandemic facilitated the use of stress testing in policy assessment calling for accurate and timely evaluation of the effectiveness and sufficiency of these mitigation measures. This article documents how the ECB’s macroprudential stress testing could address prodigious economic uncertainty and factor in the interactions between policies in conducting policy assessments. It further provides an example of stress testing as a communication tool, with a macroprudential stress test forming part of the ECB’s communications to support banks’ use of capital buffers.

The article also looks at the lessons learned from the COVID-19 crisis for macroprudential policy assessment in normal times. One of the recognised challenges of macroprudential policy is the known nature of the costs of additional capital buffers and the uncertain nature of the benefits, which depend on future events. Experience derived from the COVID-19 crisis and broad concern about the ability of the banking sector to continue lending to the economy give impetus to the application of stress testing methods with a view to establishing the forward-looking use of prudential instruments.

The article by Durrani et al. (2022)^[8] analyses stress tests as a communication device available to supervisory authorities and central banks. The article finds evidence that disclosing EU-wide stress test results plays a vital role in enhancing transparency and market discipline, thereby promoting financial stability. The authors document the fact that the stress tests carried out between 2014 and 2021 provided markets with information that they did not previously have. Following publication of the stress test results, investors were able to distinguish more effectively between viable and less viable banks, as reflected in the level and volatility of bank returns, especially in periods of greater uncertainty. Furthermore, the authors found that publication of the test results of more vulnerable banks was likely to generate more valuable information because it led to more sizeable market responses. 

This Macroprudential Bulletin provides a snapshot of the ECB’s current use of stress testing in macroprudential policy processes, only sporadically looking to the future. The opportunities for applying stress testing more broadly and the challenges for further developing it continue to emerge. In terms of opportunities, the increasing availability of transition and loan-level data, should improve the accuracy of stress testing methods and tighten cooperation between the authorities supervising the different segments of the financial sector. There is also a growing understanding of the various uses and advantages of stress testing methods among policymakers and the public. Among the challenges is the need to raise awareness of the uneven distribution of risks across various economic sectors and to comprehensively factor in the interplay between monetary policy and financial stability risks.

References

Budnik, K., Caccia, A., Dimitrov, I. and Groß, J. (2022), “Using the ECB macroprudential stress testing framework for policy assessment: lessons learned from the COVID-19 pandemic”, Macroprudential Bulletin, No 17, European Central Bank, Frankfurt am Main, June.

Budnik, K., Dimitrov, I., Giglio, C., Groß, J., Lampe, M., Sarychev, A., Tarbé, M., Vagliano, G. and Volk, M. (2021), “The Growth-at-Risk perspective on the system-wide impact of Basel III finalisation in the euro area”, Occasional Paper Series, No 258, European Central Bank, Frankfurt am Main, July.

de Guindos, L. (2021), “Macroprudential Stress Testing Under Great Uncertainty”, Financial Stability Review, Banque de France, pp.17-28, March.

de Guindos, L. (2019), “The evolution of stress-testing in Europe”, Keynote speech at the annual US-EU Symposium organised by the Program on International Financial Systems”, BIS central bankers’ speeches, Bank for International Settlements, Basel, 4 September.

di Iasio, G., Kördel, S., Nicoletti, G. and Salakhova, D. (2022), “Stressing the financial system with multiple sectors in an equilibrium approach”, Macroprudential Bulletin, No 17, European Central Bank, Frankfurt am Main, June.

Dubiel-Teleszynski, T., Franch, F., Fukker, G., Miccio, D., Pellegrino, M. and Sydow, M. (2022), “A system-wide amplification of climate risks”, Macroprudential Bulletin No 17, European Central Bank, Frankfurt am Main, June.

Durrani, A., Ponte Marques, A., Giraldo, G., Pancaro, C., Panos, J. and Zaharia, A. (2022), “Does the disclosure of stress test results affect market behaviours?”, Macroprudential Bulletin, No 17, European Central Bank, Frankfurt am Main, June.

European Banking Authority (2019), “Basel III reforms: Impact study and key recommendations. Macroeconomic assessment, credit valuation adjustment and market risk”, Paris, 4 December.