The European Central Bank (ECB) has published the results of the 2021 stress tests, which show that the euro area banking system is resilient to adverse economic developments.
The 89 banks covered in the report are all supervised by the ECB. They comprise 38 euro area banks that are part of the EU-wide stress test led by the European Banking Authority (EBA) and a further 51 medium-sized euro area banks, including three Cypriot banks.
Regarding the Cypriot banks, the results for the adverse scenario show that the Common Equity Tier 1 (CET1) capital ratio for the Bank of Cyprus and Hellenic Bank would fall below 8 per cent and it would be between 11 per cent to 14 per cent for RCB Bank. The CET1 ratio is a key measure of a bank’s financial soundness.
According to a press release by ECB, the Common Equity Tier 1 (CET1) capital ratio of the 89 banks in the stress test would fall by an average of 5.2 percentage points, to 9.9 per cent from 15.1 per cent, if they were exposed to a three-year stress period marked by challenging macroeconomic conditions.
The stress test is not a pass or fail exercise and no threshold is set to define the failure or success of banks for the purpose of the exercise. Instead, the findings of the stress test will be part of the ongoing supervisory dialogue.
Banks were in better shape at the start of the exercise than they were three years ago, but capital depletion at the system level was higher. This was because the scenario was more severe than the scenario used in the 2018 stress test.
The average overall capital depletion of 5.2 percentage points can be broken down as follows. For the 38 banks tested by the EBA, the average CET1 capital ratio fell by 5 percentage points from 14.7 per cent to stand at 9.7 per cent. The 51 medium-sized banks tested solely by the ECB show an average capital depletion of 6.8 percentage points to 11.3 per cent, from a starting point of 18.1 per cent.
The main reason for this difference in capital depletion under the adverse scenario is that the medium-sized banks are more affected by lower net interest income, lower net fee and commission income and lower trading income over the three-year horizon.
The results also show that the first key driver of the capital depletion was credit risk, because the economic shock in the adverse scenario led to loan losses. Despite the overall resilience of the banking system, new challenges have emerged from the coronavirus (COVID-19) pandemic and banks need to ensure that they properly measure and manage credit risk.
For a subset of banks, the second main driver of capital depletion was market risk. Many financial products had to be fully revalued, making this the largest single driver of market risk. This affected the largest banks in particular, as they are more exposed to equity and credit spread shocks.
The third main driver was the limited ability to generate income under adverse economic conditions, as under the adverse scenario banks faced a significant decrease in their net interest income, their trading income and their net fee and commission income.
Stress tests, now held every two years in the EU, were introduced annually in the aftermath of the global financial crisis over a decade ago, which forced taxpayers to bail out undercapitalised banks.
Friday’s test was the first that did not include UK lenders due to Britain leaving the EU last December.