EU bank regulators lay out tougher doomsday stress test

EBA factors in period of ‘low for longer’ rates and 4%-plus economic contraction

European regulators will this year test the region’s banks against the most severe post-Brexit economic conditions ever envisaged, including a contraction of more than 4 per cent in the bloc’s economy by 2022.

The European Banking Authority said on Friday that this year’s assessment of the resilience of 51 banks across the EU — still including UK institutions as it will be carried out during the Brexit transition period — would also factor in “a recession coupled with low or negative interest rates for a prolonged period”.

It will be the first time that the regulator’s biennial test include this “‘lower for longer’ narrative” as part of the most extreme scenario that it expects banks to be able to withstand. Its inclusion reflects the fact that central banks have struggled to raise interest rates since the global financial crisis.

While the EBA made no direct reference to Brexit, it stated that its worst-case economic model — of a decline in EU real GDP by 4.3 per cent between 2019 and 2022 — assumed “a strong drop in confidence” exacerbated by possible “trade and geopolitical” difficulties. It also factored in a 3.5 percentage point increase in the EU unemployment rate and a 24 per cent fall in the region’s house prices by 2022, making the scenario more severe than any the regulator had used before.

Two years ago, when the stress test was last run but “soft Brexit” trade arrangements remained a possibility, the EBA’s worst-case scenario assumed EU real GDP contracting by 1.2 per cent in 2018 and 2.2 per cent in 2019 but growing again by 0.7 per cent in 2020.

The banking regulator’s even gloomier doomsday scenario came on the same day that new data showed the eurozone economy almost stalled last quarter, due to a surprise shrinkage of the French and Italian economies.

However, the EBA indicated that its stress test scenario was not building in any new economic risks from Brexit, given that the UK’s clear-cut election result in December dispelled much political uncertainty. It also made clear its assumptions were consistent with those made by the Bank of England for its own stress tests.

Results of the EBA tests will be released by the end of July, and although there is no pass or fail threshold, they will be used by the regulator to assess how much capital EU banks need to hold. Their methodology will then be revised for 2022.

Large EU lenders are already expecting to have to hold more capital after the EBA estimated they would need another €135bn to comply with incoming Basel IV rules. With this new regime set to be phased in from 2022 and be fully in force by 2027, banks across the bloc will require a 24 per cent rise in their minimum capital levels to become compliant, the regulator said last summer.