Stress tests have helped make the banking sector more resilient since the 2008 financial crisis. In the European Union, they are used mainly to assess whether individual banks have enough capital to withstand adverse developments and to take into account Pillar 2 guidance under the Basel framework.

Stress testing can also measure banks’ ability to cope with liquidity and operational risk, as well as climate change. The time horizon of each exercise is adjusted to the relevance of the underlying risks: two to three months for liquidity and operational risk, two to five years for capital adequacy, and five to 30 years for climate change. Some stress tests take into account several risks, such as solvency-liquidity integrated exercises.

Stress tests should focus in a more balanced way on capital adequacy and profitability. Solvency levels are much higher than they were 10 years ago, but profitability is well below pre-crisis levels. In 2019, just before the Covid-19 outbreak, more than 80% of large euro area financial institutions had a return on equity below 8%.

There are many reasons for persistently low profitability: stocks of legacy assets (non-performing loans and illiquid financial assets), the effects of the ‘low for long’ interest rate environment, poor cost-efficiency, insufficient income diversification, overcapacity and higher credit risk due to the pandemic.

Rather than focusing mainly on solvency levels, it is important to give more consideration to current and future profitability, assessing sustainability under normal as well as stress conditions: Will banks manage to close the gap between return and cost on equity through credible cost reduction measures, efficiency gains, income diversification and business model adjustments? Are they in a position to raise capital through profits?

One scenario for jointly stressing solvency and profitability could be based on a depressed (but not extreme) scenario in terms of GDP and price growth, which is equivalent to assuming that current debt levels are a drag on real and nominal growth. This scenario could be defined, for instance, as the 25th (or 20th) percentile of the future distribution of real GDP growth, and not the central GDP projection. Some additional pressures on profitability (through shocks on some components of interest income and non-interest rate income) could be included, like greater penetration of fintech firms, Google, Apple, Facebook, Amazon or other non-banking providers in the banking market and the resulting heightened price competition. This would be more of a stress test weighing on structural vulnerabilities, rather than the typical cyclical test. Given the low-for-long economic environment, this scenario should have a five-year horizon, rather than the usual three years. The test should be run in parallel with a traditional stress testing exercise, overcoming the limitations of a single adverse scenario.

This supervisory exercise should rely on dynamic balance sheets accounting for a fairly complete set of managerial decisions like business model adjustments, cost-efficiency measures, income diversification and remedy measures under stress. This approach would be much more realistic than the static balance sheet one and, therefore, much more useful as a risk management tool and as a forward-looking planning exercise.

The supervisor should challenge baseline and stressed projections and, ideally, decide the final results.

Baseline projections would offer two distinctive advantages: the possibility to assess a business model’s viability and sustainability in a comparable way across banks; and second, the possibility to assess the consistency of banks’ projections over time, as supervisors would be able to identify institutions with more deficient planning procedures. Stressed projections would indicate how capital-generating capacity would be affected and how management decisions could mitigate the negative impact. Profitability metrics would play a prominent role in the exercise.

In the EU banking sector, capital levels and liquidity positions are much stronger than they were 10 years ago. The same does not apply to profitability: ROE levels are still modest for a large fraction of the banking sector and future profitability remains a key challenge. It is therefore advisable to complement the range of current exercises with more integrated capital adequacy-profitability stress testing.

Pedro Duarte Neves is a former Vice-Governor of Banco de Portugal. For more on this topic, click here to read the European Banking Institute discussion paper.