July 2018

The 2018 stress tests and IFRS 9: How will traditional banks be affected?

Stress tests measure a bank’s reaction (in terms of earnings, capital and liquidity) to a hypothetical macroeconomic scenario. The 2018 edition was launched in January and banks are expected to provide their preliminary projections by the end of June. Full results for will be disclosed in November.

Participating banks must analyse the impact of four main sources of uncertainty: credit risk, market risk, financial risks on net interest income and operational risk, including conduct risk.

Credit risk looks as a major source of uncertainty, given that banks must comply, for the first time, with IFRS 9. This new accounting standard – effective since 2018 – requests banks to allocate credit exposures into three “stages”: stage 1 (fully performing), stage 2 (exposures that have suffered a significant increase in credit risk since initial recognition) and stage 3 (non-performing exposures). For each year in the simulation horizon, institutions must simulate transition rates across stages, while stepping up provisions for exposures in stages 2 and 3 based on their estimates of lifetime expected losses.

The banks’ internal estimates, however, are subject to several constraints dictated by the European Banking Authority (“EBA”) in order to make simulations more stable and comparable. E.g., stage 3 exposures are not allowed to return to a better stage, meaning that they act as a “cumulative” variable containing an initial stock, plus all subsequent flows from performing stages. Additionally, stage 3 items cannot experience an increase in expected recoveries, nor can they earn an effective interest rate greater than the historical 2017 value. Cure rates for such exposures are set to zero (once in stage 3, there is no way back to a performing state), and the recovery process never ends (meaning that defaulted loans will sit on the bank’s balance-sheet forever).