The roots of the first stress tests led to the 2008 big financial crisis. This economic recession caused a huge breakdown for big financial institutions, several big banks were at the edge of becoming bankrupt. This situation enforced the U.S government to find a solution and save the financial system from the total collapse. The government invested more billion dollars into credit market. Since then, during weak economic periods, banks are obligated to pass government commanded stress tests. If they do not succeed, they may required to take on more capital, reduce the number of existing shareholders or the FDIC insures them deposit and the banks enter a receivership with the institution.
Below you can read the short summary of the last year's test results which were coordinated by the EBA across the EU and is carried out in cooperation with the ESRB, the European Commission, the ECB1 as well as competent authorities from all relevant national jurisdictions.
They tested how the banks' investments would fare under a baseline scenario and a crisis scenario.
The 2014 stress test included 123 banking groups across the EU and including Norway with a total of EUR 28,000BN of assets covering more than 70% of total EU banking assets.
The impact of the stress test was assessed in terms of the transitional CRR/CRD IV Common Equity Tier 1 ratio for which a 5.5% and 8.0% hurdle rate are defined for the adverse and the baseline scenario respectively. Whilst the definition of capital varies somewhat depending on national transitional rules, the EBA has ensured all jurisdictions apply the same rules for unrealized gains/losses on sovereign exposures and has provided full disclosure of the consistently defined fully implemented capital ratios under CRR/CRD IV.
To pass, banks required a core capital buffer equivalent to 8% of risk weighted assets for the base scenario, and 5.5% for the adverse. As you can see from the table, 24 banks failed the test.
Source: Report of the EBA's Results of 2014 EU-wide stress test
What can you do as an investor to predict whether your bank is failing a stress test?
First of all be financially insightful. Try to read reports and surveys. In general these are written by savvy bank analysts who are experts in this field. If you are motivated enough you can do the mathematics exercises by yourself. If you are not this kind of person, no worries. There are other ways to predict whether your bank will pass or not.
An easier way is to examine the financial ratios.The Texas ratio is kept as an indicator of bank failure. The higher this ratio the more the credit troubles.
Two types of capital are measured: tier one capital, which can absorb losses without a bank being required to cease trading, and tier two capital, which can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors. The minimum CAR when including Tier II capital may be 8%.
Beside these you should consider to look at the loan portfolio of your bank. E.g. don’t forget that insecured loans have a higher level of risk than commercial and industrial loans.
Last but not least, rank your bank and examine the concurrency. If your banks ratios are much higher than the median, it is a good sign.The first hit will be given to the banks with lower capital levels.
In conclusion, stress test is always a big challenge for the bank sector but it helps the investors to seek out good bank investments and it gives a good summary of safer institutions. So when you hear that your bank is under a stress test procedure, be confident and check your bank’s features to ensure yourself that it is a reliable institution you have invested in.