On 29 July, the European Banking Authority (EBA) published the results of its 2016 stress test.

The stress test assessed 51 banks – 37 from the euro area (single supervisory mechanism countries) and 14 from Denmark, Hungary, Poland, Sweden and the UK.

The starting point for the stress test was greater bank resilience, at least as measured by capital ratios - banks’ common equity (CET1) capital ratios have improved significantly since the 2014 stress test, from 11.1 percent to 13.2 percent, as a result of a combination of higher capital and a decline in risk weighted assets. However, this strength is offset to some extent by high levels of non-performing loans at some banks, generally weak rates of profitability and the prospect that IFRS 9 and recent Basel Committee proposals on risk weighted exposures will have a significant adverse impact on banks’ measured capital ratios.

Although the macro-economic adverse scenario used in the 2016 stress test was similar to the scenario used in 2014, a more conservative methodology for translating this scenario into an impact on capital ratios resulted in larger and more widely dispersed declines in capital ratios across the banks. Part of the wider dispersion was also due to different arrangements across countries in the phasing-in of the Capital Requirements Regulation (CRR).

By the end of 2018, capital ratios across the sample fall by almost 4 percentage points to 9.4 percent on average as a result of the stress scenario. On average, banks from Germany (5.4 percentage points), Ireland (7 percentage points) and the Netherlands (5.7 percentage points) suffer the largest declines in capital ratios.

Most of the overall decline in capital ratios is due to credit risk losses. In addition, for some banks that are heavily reliant on interest income an adverse impact on net interest income leads to a significant decline in profits. Overall, the stress scenario has a marked impact on banks’ profitability, turning the return on equity negative in 2016 and close to zero in 2017 and 2018.

The largest decline in the CET1 capital ratio at any individual bank is 14 percentage points, at Banca Monte dei Paschi di Siena, whose capital ratio falls from 12 percent to -2 percent.

Thirteen other banks show a decline of more than 5 percentage points in their capital ratios, but in all these cases the post-stress capital ratio remains above 5.5 percentage points (which some other stress tests have used as a minimum acceptable post-stress result, based on the 4.5 percent minimum CET1 ratio in Basel 3 and the CRR, plus a 1 percent capital surcharge for a systemically important bank).

Apart from Banca Monte dei Paschi di Siena, Raiffiesen-Landesbanken-Holding (6.1 percent) of Austria, Banco Popular Espanol (7.0 percent), Unicredit (7.1 percent), Barclays (7.3 percent) and Commerzbank and Allied Irish Banks (both 7.4 percent) have the lowest post-stress capital ratios.

The 2016 EBA stress test did not impose a pass/fail threshold, but the results will feed into the supervisory assessment of each bank in two ways. First, the capital depletion results will feed into the setting of Pillar 2 capital guidance (which will not affect the maximum distributable amount (MDA)). Second, the manner in which a bank manages its stress testing – for example, timeliness, accuracy of data and compliance with methodology – will feed into the Pillar 2 requirement itself (which does influence the MDA threshold).

The results show that some banks remain in a vulnerable position despite the improvement in their pre-stress test capital ratios, not least because of some combination of their specific business models, high levels of non-performing loans and weak profitability. This may increase the cost of raising capital, issuing debt and raising deposits. In particular, this may make it considerably more expensive and difficult for some banks to meet minimum requirements for loss absorbing capacity (MREL), when these are set on a case-by-case basis.

The stress test results also have to be seen in the wider context of the introduction of IFRS 9 and continuing regulatory reform, the impact of which was not tested in this exercise. The revised market risk framework that has already been finalised by the Basel Committee, together with the proposals for credit risk, operational risk and the capital floor, will reduce the capital ratios of many banks, in some cases by at least 2 percentage points. Further ahead, any revisions to the risk weighting of sovereign exposures could have an additional significant adverse impact on some banks’ measured capital ratios. This is further discussed in the latest KPMG report, Banks’ strategies and business models: capital myths and realities.

A package of measures to improve the position of Banca Monte dei Paschi di Siena hasalready been announced.

Some of the banks with the lowest post-stress capital ratios may also need to take some action to bolster their capital positions in response to a combination of the stress test results, any additional Pillar 2 capital guidance or requirements imposed by their supervisors, the prospective impact of IFRS 9 and further regulatory reforms and any investor and depositor concerns.