banking supervision & regulation

Since 1996, banks are required to perform a stress test in order to assess their ability to overcome possible difficulties. This test is not conducted on a best scenario case, on the contrary, it comprises many worst scenario cases to test the effectiveness of capital banks. However, it is only from 2007 that the test is regularly performed by financial third parties to ensure best practices by banks.

COVID-19 and EU-wide stress testing

In light of COVID-19 outbreak, the European Banking Authority (EBA) has decided to postpone the EU-wide stress test to the following year “to alleviate the immediate operational burden for banks at this challenging juncture”. On the other end, The Federal Reserve has not let the pandemic prevent it from conducting the tests and, on Thursday, it released the results for 2020 with additional sensitivity analyses concerning the specific situation the world is going through.

Downside scenarios

Besides the normal stress test conducted, three possible downside scenarios that could result have been analyzed. In all of them, the unemployment rate reached its peak between 15.6 and 19.5 percent and loan losses for the 34 banks under scrutiny appeared to be between $560 billion and $700 billion, with decreasing aggregate capital ratios.

The Federal Reserve, in light of these results, capped dividends and banned share buybacks by big US banks until the fourth quarter of 2020, in order to preserve capital. Jamie Dimon, JPMorgan Chase’s CEO, said buybacks were unlikely to resume since the future is not yet clear. As a matter of fact, the eight biggest US banks, including JPMorgan, had already suspended buybacks. Finally, re-evaluation of longer-term capital plans had also been required.

The big picture

The issue here is whether the measure adopted by the EBA in front of this phenomenon has been a cautious one. Is it a safe measure to allow greater flexibility to banks in predisposing their capital requirements? Or is it a better action than the one adopted by The Fed? Could it be a sign of greater responsibility for conducting the stress tests and taking actions by imposing strict requirements to ensure the bank's resilience?