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Predictability of EU Bank Stress Test Results

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predictability of eu bank stress test results

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Global Economy and Finance Journal
Vol. 8. No. 1. March 2015 Issue. Pp. 1 – 10

Predictability of EU Bank Stress Test Results
Kian Guan Lim*
Since the global financial crisis of 2008 and the European sovereign debt
crisis of 2009, the banking system in EU and in the Eurozone in particular
has been under-performing and weak. The EU bank stress tests were
conducted for capital adequacies and to avoid systemic risks. The first test
results indicated that of over 120 banks, seven banks failed the stress
tests. Spain, with 27 tested banks, made up the biggest portion of the test
banks. In this paper we examine using nonlinear LOGIT and PROBIT
regression models, the predictability of stress test failures on the sample of
Spanish banks, and identify the principal risk factors to watch out for. We
find that size, returns performance, and to some extent deposit base are
significantly more important than other measures that may be small such
as non-interest incomes and other measures that could be fungible such
as altering debt durations without materially improve asset qualities or
reducing liability servicing capacities. Predictability would enable advance
warning and more time for such banks to repair and shape up.

JEL Codes: G210 and G2

1. Introduction
Since the global financial crisis of 2008 and the European sovereign debt crisis of 2009, the
banking system in the European Union (EU) and in the Eurozone in particular has been
under-performing and weak. The EU bank stress tests were conducted for capital
adequacies and to avoid systemic risks. In this paper we study using nonlinear LOGIT and
PROBIT regression models, the issue of the predictability of the stress test failures, and
identify the principal risk factors to watch out for.

The academic literature on bank stress tests predictability is sparse. Most published papers
including research papers from financial institutions and public authorities dealt with issues
related to the benefits and consequences of such stress tests. For examples, Wolff (2011)
provides a discussion on the need for EU stress tests with respect to significantly declining
bank equity prices, and attributes the latter to two major factors – the loss of confidence in
Euro area banking system and the sovereign debt problem of Greece. Zuzana and Petr
(2012) express how stress tests can be useful to detect systemic risk in banking sector even
in emerging markets such as Russia. Beltratti (2011) and Petrella and Resti (2013) find
some evidence of useful information arising out of stress tests in reducing bank opacity.
Peristiani et. al. (2010) reported similar kinds of results in the U.S. based tests. Cardinali
and Nordmark (2011) look at stock abnormal returns surrounding the EU stress tests and
concluded that there were either no significant change or else banks to be tested showed
negative returns with announcement of a more stringent test methodology. These studies,
however, do not discuss if accounting information contained in the financial reports of banks
offer any predictability of stress test results in the immediate future or in the following
months when stress test is to be conducted.

* Lee Kong Chian School of Business, Singapore Management University. The research assistance provided by
Cheong Sok Fen in this project is gratefully acknowledged. The author also acknowledges the project funding from
the OUB Chair endowment.

, Lim
Another line of literature seeks to understand the effectiveness of stress tests when given
different macroeconomic scenarios and their risk implications. Foglia (2009) reviews macro
stress testing methods developed at selected central banks and supervision authorities for
stress testing the credit risk of banks using bank-specific measures of credit risk as inputs.
Lu and Yang (2012) uses a vector autoregression method to find key predictive variables of
non-performing loans in Chinese commercial banks. They concluded that lower growth rate
of GDP, slump in CPI, slowdown in supply of nominal currency, and residential property
prices were key predictors.

Covas et.al. (2013) employ a dynamic panel quantile econometric framework to estimate
major components of net charge-offs and pre-provision net revenue in 15 U.S. bank holding
companies using data from 2007-2011. Macro-stress factors were used as inputs and
projects of future losses in terms of probability densities were possible, but it was not related
directly to event-based dependent variables such as actual failure of a stress test that could
spell immediate negative market reaction. Kupiec (2000) analyses the difference between
stress tests and value-at-risk capital allocations. In these studies, there was no direct usage
of bank accounting numbers nor any empirical estimation of stress results.

The key contributions of this paper include the investigation of the predictability model for
how EU banks would pass the stress tests. Predictability would enable advance warning
and more time for such banks to repair and shape up. This is one robust policy of re-
building a considerably weakened European banking system through more thorough
investigation of bank problems by the market using pre-stress test financial statements as
information.

The EU as of 2014 is an economic and monetary union of 28 member states located in
Europe. Its early beginning was the European Economic Community (EEC) based on the
EEC Treaty of Rome in 1957 that brought together for purposes of trade and economic
expansion France, Germany, Italy and the Benelux countries. The Maastricht Treaty, signed
in 1992 and enforced in 1993, opened the way to political integration by reinforcing the
powers of the European Parliament, launching the process for economic and monetary
union (EMU), and transforming the EEC to become the European Union. The European
Exchange Rate Mechanism (ERM) was subsequently introduced on 13 March 1979 to
reduce exchange rate volatility and attain monetary stability in Europe. This eventually led to
the introduction of a single currency, the Euro, on 1 January 1999.

However, so far only 18 of the 28 EU member states or member countries have adopted the
Euro as their common currency. This group of 18 countries as a major part of EU consists of
Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Latvia,
Luxembourg, Malta, The Netherlands, Portugal, Slovakia, Slovenia, and Spain, and are
collectively called the Eurozone or Euro area. The key monetary policy unit of the EU is the
European Central Bank (ECB) which has the exclusive right to authorize and supervise the
issue of Euro banknotes by the national central banks of individual countries of the
Eurozone.

The American subprime crisis that started the global financial crisis of 2008 had serious
repercussions on banking systems worldwide, including banks in the EU. Some EU
countries such as Ireland and Spain had similar real estate bubbles that burst. Other EU
countries such as Greece, Italy, and Portugal had poor public finances. These problems
were exacerbated by the global financial crisis, and led to a generally weak banking system.

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