Can Stringent Stress Tests Help Banks Combat Pandemic Risk?

The 2008 financial crisis caught the financial system unaware and hit the economy hard, but regulators worldwide adequately intervened, injecting the liquidity necessary to combat the distress. This time around, the situation is a little different: it is very difficult to ascertain the impact of the ongoing pandemic on the financial system.

Already, many financial authorities globally are considering necessary interventions to inject required liquidity, deferring or reducing tax payments and even providing tax relief if required.

In the wake of the 2008 financial crisis, global banks saw a slew of regulations aimed at making them more resistant, proactive and robust in handling economic downturns arising out of such negative scenarios. Exercises such as stress testing became more prominent after the financial crisis, and they’ve been undergoing constant updates ever since.

Globally, each regulator has their own version of the stress-testing exercise. In the European region, stress-testing guidelines are managed by the EBA (Euro Banking Association) and impact more than 100 banks. In the U.K., stress testing guidelines fall under the purview of the PRA (Prudential Regulation Authority), impacting seven large U.K. banks.  In the U.S., stress testing is called CCAR (comprehensive capital analysis and review). The stress-testing exercise focuses on testing the resiliency of a financial institution in the event of an economic downturn, something the world is currently staring at in the form of the COVID-19 global pandemic.

Apart from the standard data submission, the stress-testing exercise also models loss events based on idiosyncratic (that is, organization-specific) and regulatory scenarios, which provides a view of the soundness of a financial institution’s capital plan and how well capitalized they are to overcome the economic downturn.

Financial institutions have been conducting stress-testing exercises for more than a decade, but the current conditions warrant more stringent stress testing, as the realities at play will require them to consider additional inputs around factors like:

Growth in the Unemployment Rate

The unemployment estimates that are usually factored in stress tests may need to be revised (e.g., in the U.S., the unemployment scenario released on February 6 for CCAR considers a rate of 6.5 percent for a baseline scenario and 10 percent for a severe scenario). It is already evident that in the current scenario, estimates will need to be revised.

Declining Interest Rates

The recent interest rate cuts done by the Bank of England and the Federal Reserve are going to add an additional strain on banks’ profitability. Local banks, which are not diversified like larger banks are, will take a severe hit from low interest rates, which will be an additional blow, along with deteriorating credit quality of its corporate and retail borrowers. It is also expected that other banking regulators may implement similar moves in their respective geographies.

Increase in Nonperforming Loans

The nonperforming portfolio of the banks is on a steady rise globally, and if the current pandemic situation grows, banks are bound to see more defaults and corporate downgrades.

But the silver lining is that banks globally have factored, modelled and improvised many such scenarios in their stress-testing exercises during the last decade and are well-positioned to implement strategies to contain the losses arising out of the ongoing pandemic, along with continuing their regular business activities. Through stress-testing, they have built forward-looking capital plans and have also accounted for additional liquidity needed in times of crisis, which will also aid them in combating the crisis.

Regulators have also been stringent in reviewing capital plans and stress-test results, which has led to many MRAs (matters requiring attention) and MRIAs (matters requiring immediate attention) for banks to optimize their capital planning in the event of an economic downturn. Given that the stressed conditions arising from the pandemic will impact financial and economic stability, regulators must seriously consider more stringent stress testing that considers current economic indicators – including unemployment rates and housing prices – to better determine whether banks are well-capitalized and have sufficient liquidity to withstand the current crisis.