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Macroprudential Stress Testing Prometeia
The most original innovations often stem from
necessity or are born for the purposes of overcoming
unforeseen difficulties. This is the case for
macroprudential stress tests, namely a set of analysis
techniques used by financial supervisory authorities
since the great global financial crisis in 2007-2009.
This approach has resulted in the achievement of
significant advances in the grasp of the mechanisms
governing the interactions between the financial
system and the real economy on the one hand, and
between the former and international relations on
the other. This article proposes to address three issues:
when were stress tests introduced in Europe; what
microprudential stress tests are and their purpose;
and what are their most recent developments.
All models are wrong, but some are useful.
George E. P. Box (1919-2013)1
1 George E.P. Box was
a British statistician,
pioneer in process
quality control, analysis
of time series, design
of experiments and
Bayesian inference
) 3 (
Macroprudential Stress Testing Prometeia
ith the great financial crisis in 2007-2009, supervisory authorities world-
wide unexpectedly realised that a number of banks, while well capi-
talised2, were facing serious difficulties within a very short time due to losses
accumulated on specific held assets (Asset Backed Securities, ABS) or on the
grounds of liquidity. The numerous ensuing banking failures and the subsequent
financial crisis are common knowledge. In Europe, the impact of the crisis fur-
ther expanded with the so-called “sovereign debt crisis” that, between 2011 and
2012, affected countries of which the governments were most heavily indebted
in relation to GDP.
The reasons and root causes, as well as the transmission channels of the
great financial crisis will not be addressed herein. The latter triggered a deep
change in banking supervisory regulations on a global scale, with the transition
from the so-called Basel II agreements that had just come into force in 20073,
to the subsequent Basel III agreements in 2010, reinforcing the capital require-
ments of banks and introducing a wealth of restrictions and controls relating to
their degree of liquidity.
Since 2009, the supervisory Authorities of various countries, such as the
USA, Great Britain and the European Central Bank in the Euro area, started to
internally conduct a series of stress tests on the monitored banks following a
top-down approach, in order to better orient their monetary policy and super-
visory decisions.
In 2014, prior to the launching of the Single Supervisory Mechanism
(SSM) and upon the initiative of the European Banking Authority (EBA) in col-
laboration with the ECB, an extensive and accurate analysis of the assets held
by the 130 main European banks to be monitored by the Frankfurt authorities
was conducted (comprehensive assessment). This analysis also included a stress
test at the level of each individual bank with a bottom-up approach. The EBA
EU-wide stress tests, that is to say extended to larger European banks (signifi-
cant institutions) were then replicated in 2016 and will be repeated every two
years. The next will be conducted in 2018.
At the end of 2014, the entire Supervisory Review and Evaluation Pro-
The introduction of stress tests
in Europe
W
2 That is to say,
those banks whose
assets and equity
were aligned with
the requirements set
out by the very same
supervisory authorities
3 Although finalised
since 2004, the Basel II
agreements became active
only in January 2007
) 4 (
Macroprudential Stress Testing Prometeia
cess (SREP) was reformed. This is the annual process in which supervisory au-
thorities assess the situation of each individual bank: the business model, the
governance of equity risks and liquidity risk. Stress tests therefore became part
of the instruments used for the risk assessment of individual banks on a perma-
nent basis.
Stress tests and reverse stress tests were also introduced within the
context of the “recovery plans” under the new European legislation on banking
resolution (BRRD).
It is no exaggeration to say that today, ten years after the onset of the
Great Crisis, all risk managers within medium-large banks carry out at least one
stress test per year for management and regulatory purposes.
he purpose of microprudential testing for any bank may be explained by
drawing the following parallel example. Just as athletes taking part in
sporting competitions are required to undergo ECG monitoring on a regular ba-
sis to detect any potential cardiovascular anomalies arising only upon exertion
(that, conversely, would not emerge at rest), banks aiming to compete in finan-
cial intermediation must undergo tests to appraise their resistance to periods of
prolonged recession in particularly adverse scenarios.
When a bank fails to adequately pass stress tests, the supervisory au-
thorities may take action by imposing measures of increasing intensity, such as
organisational or strategy changes, an increase in liquidity buffers, the suspen-
sion of payment of dividends or an increase in capital.
The EU-wide stress tests organised by the EBA are mandatory for the
larger banks monitored by the ECB and consist of simulations conducted at the
level of each individual bank, with the primary aim of evaluating their financial
soundness.
In brief, the characteristics of the EBA stress tests are clarified as follows:
A dedicated European Systemic Risk Board (ESRB), which relies on data and re-
sources provided by the ECB, develops two macro-financial scenarios identical
for all banks: a baseline scenario expressing the consensus forecasts and an ad-
Microprudential testing by the EBA
T
) 5 (
Macroprudential Stress Testing Prometeia
verse scenario representing the rather unlikely, albeit not unrealistic, negative
evolution of the economic and financial situation. These scenarios are delivered
to all participating banks.
The banks undergoing stress testing should simulate the evolution of
their budgetary developments over a three-year time horizon: capital situa-
tion and income statement; regulatory capital and the so-called Risk Exposure
Amounts, REA, also referred to as Risk Weighted Assets, RWA. There is a spe-
cial focus on solvency indicators: CET1 capital ratio, which is the ratio between
the best liable equity capital (the Common Equity Tier 1, CET1) and the RWA.
For the test to be successful, this ratio at the end of the simulation horizon must
be above a specific threshold. In the first stress-testing edition in 2014, the CET1
capital ratio thresholds were respectively equal to 8% for the baseline scenario
and 5.5% for the adverse scenario. Banks falling below one of the thresholds
were required to submit an action plan for the recapitalisation of the business.
By contrast, in the second stress-testing edition in 2016, the EBA did not make
the thresholds explicit, even if the substance of the test remained unaltered.
Figure 1 illustrates the aggregated results of the 2016 EBA stress tests:
the evolution of the aggregated CET1 capital ratio percentage that, from an in-
itial 13.2% in 2015, drops to 9.4% at the end of 2018: a 380-basis-point negative
impact within the European average.
Figure 1
Evolution of the
aggregated CET1 capital
ratio % and impact (bps)
in relation to the initial
figure in 2015 (bps)
Source:
EBA, ST 2016 Results
) 6 (
Macroprudential Stress Testing Prometeia
Instead, Figure 2 illustrates the impacts of stress testing on the CET1 capital
ratio over the three years of simulation between 2015 and 2018 in the adverse
scenario per individual bank4. As shown, there is a great diversity of results
across the different banks.
4 The impacts are
detailed in the two
scenarios, “phased-in”
or “transitional” CET1
capital ratio, calculated
on the basis of a gradual
transition provided for by
the Basel III regulations
until 2018, and “fully
loaded” CET1 capital ratio,
namely according to the
comprehensive regulations
in force after 2018
Figure 2
Impact on the CET1
capital ratio between
2015 and 2018 in the
adverse scenario per
individual
Source:
EBA, ST 2016 Results
) 7 (
Macroprudential Stress Testing Prometeia
In its present configuration stress-testing, while based on macro scenarios de-
veloped by the ESRB, is conducted according to a “microeconomic” approach.
The calculations are made by each individual bank and, as mentioned, follow a
bottom-up basis: banks use their own management systems and usually summa-
rise the data of their managed portfolios from a very granular database at the
level of each individual operation.
The preliminary results processed by the banks are then forwarded to
the supervisory authorities and are subject to a careful “quality assurance” pro-
cess, with a “traffic-light” returned report system: “green light”: go-ahead; “yel-
low light”: request for further clarifications and information; “red light”: blocked
and returned to sender for new processing. In order to formulate their own
opinions and identify any potential abnormalities, the supervisory authorities
rely on different systems. The most important is an actual top-down budget
simulation model of the individual bank, that uses aggregated budget data and
the reports received for monitoring purposes and a sophisticated benchmark-
ing system, comparing the performance of similar size and with similar business
models.
The main characteristic of the EBA EU-wide stress tests is that they are
based on the so-called ‘static balance sheet’ approach: in the course of the
three-year simulation period, any variation in the volumes of the masses man-
aged are considered in relation to those at the start of the period. In other
words, no bank can grow with new loans to customers, deposits or bonds issued
to customers, or an increase in the volume of managed savings, even indirect-
ly (assets under management). As the lending and funding transactions expire,
they are reinvested in the same type of original transactions. This scenario aims
to equate all banks taking part in the stress testing (playfield levelling), irre-
spective of the differences in growth provided for by the strategic plans of the
individual businesses.
The sole budget item that is allowed to grow during the simulation is the
one relative to non-performing loans, that shift their status from performing
loans to defaulted on the basis of the probability of default as estimated by the
bank and that then determine the value adjustments on loans, according to the
estimated loss rates (Loss Given Default, LGD). The probability of default and
the LGD are estimated by the individual banks via own “satellite models”, based
) 8 (
Macroprudential Stress Testing Prometeia
on the economic scenarios provided by the ECB and especially in the adverse
scenario can reach very high levels as compared to the current ones.
The “rules of the game” of such testing include some particularly strin-
gent ones for commercial banks. First, the bank cannot recover any amount on
assets in a state of insolvency (no workouts on defaulted assets): this circum-
stance is all the more burdensome the greater the value of the non-performing
loans5. During the simulation, a deteriorated credit rating of the bank is also
hypothesised, to generate an increase in the cost of borrowing of the bank itself
that cannot be recovered via an increase in the rates for loans to customers and
the ensuing compression of the interest margin of the bank6.
The stress testing part concerning the liquidity risk is, on balance, rela-
tively limited. However, a strong negative impact is taken into account on the
value of Government securities and other securities in the portfolios of financial
assets held for sale and negotiation purposes7.
U-wide stress tests of the EBA chiefly represent a microprudential and
severe assessment of the solvency of the individual banks monitored by
the ECB, useful for preventive actions in specific situations. This is an extremely
useful test, although insufficient per se from the perspective of the supervisory
authorities.
As explained exhaustively by the Vice-President of the ECB, Vítor Con-
stâncio, in a speech given at the London School of Economics in October 20158
on the role of stress testing and macroprudential policy, from the viewpoint of
those having to make economic and financial policy decisions aimed at monitor-
ing and limiting the so-called “systemic risk”, this test presents an assortment of
limits.
Systemic risk is defined by the ECB itself as “the risk that financial in-
stability may significantly damage the supply of financial products and services
by the banks and financial institutions to such an extent that economic growth
and general welfare might be seriously affected”9. The basic idea is that financial
crises imply considerable costs for the real economy; therefore, the supervisory
Macroprudential testing by the ECB
E
5 Typically, in the real
world, banks recover a
significant portion (on
average 40%) of the
defaulting loans over
a number of years (for
Europe, on average 3
years, for Italy 5 years)
6 The compression
of the interest margin is
all the more intense the
lower the initial rating of
the bank itself
7 Recently, some authors
have raised the issue about
how to render stress tests
more accurate and in a way
more “severe” owing to the
market risks embedded in
the so-called “level 3 assets”,
namely the unlisted securities
that are evaluated according
to bank’s internal models
8 Vítor Constâncio:
“The role of stress
testing in supervision and
macroprudential policy”.
Keynote address by Vítor
Constâncio, Vice-President
of the ECB, at the London
School of Economics,
London 29 October 2015
(see R. Anderson Ed.
(2016), Stress Testing and
Macroprudential Regulation:
A Transatlantic Assessment,
CEPR Press)
9 ECB Financial
Stability Review
December 2009,
Special Features B
) 9 (
Macroprudential Stress Testing Prometeia
authorities should do their utmost to prevent them.
There are essentially three key “sources” of systemic risk: macroeco-
nomic shocks on aggregate demand or supply; imbalances stemming from pub-
lic or private over-indebtedness; contagion risks resulting from high levels of
interconnection and “herding behaviour”.
The macroprudential policies adopted by central banks pursue myriad
objectives along diverse dimensions10:
Examples of macro prudential decisions include the variation in the so-
called “capital buffers”, the additional layers of minimum capital that banks must
hold in a specific period. Alternatively, the introduction of binding rules in the
allocation of funding such as a ceiling for the ratio between the mortgage on a
property and its value, namely the loan-to-value ratio.
In financial literature since 2008, various ratios have been proposed for
measuring the current level of system risk, as well as the marginal contribution
of each individual financial institution to the overall systemic risk. Nevertheless,
from the standpoint of the supervisory authorities, none of the indicators sug-
gested so far has proved useful, in practical terms, to guide the decisions for
intervention on the financial system in order to prevent crises from forming or
to guide it out the “quicksand” of an existing crisis.
For this reason, the ECB has decided to invest in the development of
a set of its own “upgraded” macro prudential models that leverage the set of
data and instruments used for microprudential stress testing on the solvency
of banks. The approach employed by the ECB and the set of instruments de-
veloped, “Stress-Test Analytics for Macro prudential Purposes in the Euro area”
(STAMP€), is outlined in detail in a publication dated February 201711.
What are the characteristics of this new approach?
10 www.ecb.europa.eu/
ecb/tasks/stability/
html/index.en.html (ECB,
web page dedicated to
Financial stability and
macroprudential policy).
time dimension: to prevent an excessive accumulation of risks,
stemming both from external factors as well as from any potential
market failures, and to smooth the fluctuations over the financial cycle;
transversal dimension: to render the financial sector more resilient to
shocks and to limit contagion effects;
structural dimension: to encourage the use of a broad perspective at
system level in financial regulations for market operators in order to
create a set of correct incentives for market participants.
11 STAMP€, Stress-
Test Analytics for
Macroprudential
Purposes in the
euro area, Edited
by Stéphane Dees,
Jérôme Henry and
Reiner Martin (https://
www.ecb.europa.
eu/pub/pdf/other/
stampe201702.en.pdf)
) 10 (
Macroprudential Stress Testing Prometeia
Based on the adverse scenario, identified as a potential “threat” to the stability
of the financial system, the balance sheets of the individual financial institutions
are simulated as in the EBA EU-wide stress tests. This time, however, the top-
down and dynamic balance sheet approach is used.
Whereas in the EBA microprudential stress testing no adjustment by the
bank’s management of the adverse scenario is permitted in any way, in this type
of simulation conducted independently by the ECB, the possibility of dynamic
adjustment by the management to the variations in the macroeconomic frame-
work or to the actions of the supervisory authorities is introduced.
Banks may react in various ways: deleveraging their riskiest activities,
proceeding with capital increases, if the conditions of the stock market so allow,
or accelerating the recovery of non-performing loans also via transfers. A com-
bination of the various alternatives is also feasible.
The impact resulting at system level shall differ according to the behav-
iour most pursued by the individual banks. For instance, let us assume that,
following a slowdown in the economic cycle and a subsequent increase in the
capital ratios imposed by the supervisory authorities (or required autonomous-
ly by the market), banks react by reducing the loans granted to their customers,
specifically those considered the riskiest. In so doing, the credit rationing to the
economy would trigger a vicious circle that could engender a recession even
more severe than the one originally conceived.
Figure 3
The structure of
the ECB modules
for the top-down
analysis of the solvency
of the banks
Source:
ECB, publication
STAMP€ feb. 2017,
chapter 2
) 11 (
Macroprudential Stress Testing Prometeia
12 The first is a
Dynamic Stochastic
General Equilibrium
(DSGE) model and
the second is a Global
Vector Autoregressive
(GVaR) model
Figure 4
Macroeconomic
feedback effects of
the financial economy
on the real economy in
the STAMP€ System
Source:
ECB, publication
STAMP€ feb. 2017,
chapter 2
The behaviour of the individual banks is simulated via models for the re-com-
position of loans and their collection, based on criteria for optimising the risk/
return profile. The results of the simulations conducted by the ECB tend to
confirm the widespread opinion that in response to negative shocks entailing a
deterioration of the credit risk and tight constraints on collection, banks tend to
divest assets as opposed to proceed with increases in capital and maintain the
existing leverage.
Once the reactions of the banks has been defined, it is crucial in macro-
prudential terms to grasp the interconnection between financial economy and
real economy. To this end, the ECB uses two different macroeconomic models12,
tailored to each individual European country, that adopt the behaviour hypoth-
eses of the banks and allow for the development of the subsequent impacts on
GDP, consumption and investment, and different spill-overs across the diverse
economies.
For instance, in Figure 4 illustrates the aggregate impact (estimated on
2013 data) on the CET1 capital ratio of a stress test in different cases: static, at
variable trends, with dynamic managerial actions, with macroeconomic feedback.
Another significant limit of microprudential EBA EU-wide stress test-
ing is represented by the complete lack of controls on the so-called “second
round effects”.
An important source of second round effects that should not be over-
) 12 (
Macroprudential Stress Testing Prometeia
13 Integrated Dynamic
Household Balance
Sheet (IDHBS) model
of the euro area
household sector
14 Household Finance
and Consumption
Survey (HFCS)
looked stems from the high degree of interconnection across banks, which may
entail contagion effects able to amplify the initial effects of a financial shock. For
instance, the insolvency of a bank may bring about losses for other strongly ex-
posed financial intermediaries. To properly address the dependencies that in-
terbank deposits and derivative contracts imply across banks, especially those
of greater systemic proportions, representation models archetypal in the anal-
ysis of social networks have been developed (network analysis). Such models
make it possible to know in advance, given the existing connection network,
where and how the shock wave caused by the failure of a bank would have a
more significant impact (financial contagion).
A further extension of the simulations of microprudential stress testing
is to consider the interactions between the banking sector and the rest of the
economy, from households and enterprises to other non-bank financial institu-
tions. In order to take into account in an increasingly realistic manner the sec-
ond round effects, the ECB has introduced among its instruments new models
that appraise such interactions.
For instance, a household-specific modelling has been developed13
based on the results of an array of sample surveys on household budgets14 and
extended to 15 European countries, to obtain a projection and an independent
estimate of the demand for credit and of the probability of default of the pri-
vate sector, specifically in the residential mortgage segment. The possibility of
submitting household budgets to stress testing is especially relevant in macro
prudential terms, to guide the supervisory authorities in imposing caps to indi-
cators such as loan-to-value, debt-to-income and debt-service-to-income. The
imposition of caps to such indicators in granting bank credit indeed affects the
actual demand for mortgage loans by households, the level of debt of the econ-
omy and, accordingly, the entire evolution of the financial and economic cycle.
Phenomena of diffusion of a crisis may also spring from the plain loss
of value of equity securities issued by banks, such as shares or bonds, on the
portfolios of other financial institutions. Specialised models have been devel-
oped for the simulation and stress testing of balance sheets of non-bank finan-
cial segments: insurance companies, pension funds and social fund schemes,
investment funds and other financial institutions (that constitute the so-called
“shadow banking system”).
) 13 (
Macroprudential Stress Testing Prometeia
Figure 5
Structure of the
macroprudential
extension of the EBA
monitoring stress tests
Source:
ECB, publication
STAMP€ Feb. 2017,
chapter 3
Lastly, explicit macro liquidity stress tests have been introduced that
attempt to grasp in macro terms the two dimensions of the issue: the correla-
tion between liquidity and solvency at the level of the individual bank and the
repercussions of a liquidity crisis on the financial system in its entirety.
Figure 5 displays an overview briefly summarising the various instru-
ments making up the new system of the ECB because of the macro prudential
extension of stress testing.
Those responsible for the macroprudential tests of the ECB describe
STAMP€ as an evolving, complex system, indicating its development and opti-
misation guidelines. This fascinating challenge shall pave the way for new paths
and new questions. No doubt, it represents a step forward in understanding
complex economic and financial systems.
The American economist John Kenneth Galbraith, in the final part of his
book “A History of Economics” (1987), on the topic of future developments in
economic theory, predicted that in future: “The distinction between microeco-
nomics and macroeconomics will blur and disappear”. With the evolution of the
instruments and techniques of macroprudential stress testing, this time is fast
approaching.
) 13 (
Simplicity does not precede complexity, but follows it.
Alan Jay Perlis (1922-1990)15
15 Alan Jay Perlis
was an American
computer scientist,
pioneer in computer
science and in the first
programming languages
rometeia is a global provider of consulting services and FinTech solutions
focused on Risk & Performance Management. Since 1974, the firm supplies
highly specialized advisory, analytical tools and research programs, integrating
quantitative models, market and customer data, financial and economic scenar-
ios. With 750+ industry experts, Prometeia serves over 200 financial institutions
in 20 different countries, through a consolidated network of foreign branches
and subsidiaries located in Europe, Africa and the Middle East.
With particular reference to the European market, Prometeia collabo-
rates with over 15 banking groups operating within the SSM regulatory space, in
particular in the areas of:
In the specific field of Regulatory Stress Testing, the company has assisted a large
numbers of clients in performing the exercises required by the European regula-
tor in 2014 and 2016, leveraging the capabilities of ERMAS, the integrated SW plat-
form developed by Prometeia to support Holistic Balance Sheet Management.
ERMAS v.5. has been enhanced to cover the extensive requirements
set by the European Central Bank for integrated stress testing: the solution
supports the projection of net interest income, REAs and loss provisions, under
multiple scenarios and consistently with new IFRS9 principles.
Prometeia track record for ECB Stress Testing
P
Macroprudential Stress Testing Prometeia
) 14 (
• Asset Liability Management
• Liquidity Risk and Interest Rate Risk in the Banking Book
• Capital Management and Optimization
• Compliance with ICAAP and ILAAP requirements
• Regulatory Stress Testing
Source Systems
& Data Feeds
ERMAS
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About us
) 15 (
PrometeiaMacroprudential Stress Testing
Founded in 1974 as an independent institute for eco-
nomic research by a group of young university profes-
sors in Bologna, in 1981 Prometeia began offering analy-
sis services to businesses and financial intermediaries.
Since the ‘90s, the company’s activities have focused
increasingly on the integration of research, analysis,
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Prometeia’s approach to Enterprise Risk Management
is based on the development of quantitative models
and analysis methodologies. The production of highly
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We are a leading provider of
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Our combination of tech proposition,
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to Prometeia’s business model and value proposition.
) 16 (
PrometeiaMacroprudential Stress Testing
-> with over 750 industry experts
-> more than 40 years of
economic expertise
-> we serve more than
200 financial institutions,
including 50 primary
banking groups in EMEA
-> in 20 different countries
-> through a network of branches
in Europe, Russia, Turkey,
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Our unique business
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RISK
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