The disciplining effect of supervisory scrutiny in the EU-wide stress test

Since the financial crisis, stress tests have become an important supervisory and financial stability tool. Against this background, a question is whether stress tests contribute to financial stability by promoting risk reduction in the banking sector as recent evidence suggests. Stress tests offer deep insights into banks’ vulnerabilities to supervisors and the public through an intense supervisory process. In a recent paper, we show that higher supervisory scrutiny led to a disciplining effect for banks that were part of the 2016 EU-wide stress test, coordinated by the European Banking Authority (EBA) and conducted by the European Central Bank (ECB).

How supervisory scrutiny is exerted in stress tests

In Europe, stress tests involve interactions between banks and supervisors on banks’ risk management practices as well as confidential communications about best stress-testing practices and techniques. We use data on these confidential interactions to approximate how much scrutiny was exerted on each bank under the direct supervision of Single Supervisory Mechanism (SSM) during the 2016 EU-wide stress test. These interactions arise as part of the constrained bottom-up approach pursued in the EBA-coordinated exercises (see figure 1). In this context, banks use their own internal models to generate projections, for example, for credit losses. Meanwhile, banks’ projections are challenged by the competent supervisory authorities typically by applying top-down models and other challenger tools. In the presence of material deviations between these two sets of projections, “flags” are triggered and later discussed between supervisors and banks. Banks need to comply with or explain the issues raised in the interactions with the ECB. We construct a scrutiny measure by counting the flags related to credit risk projections. Intuitively, banks that received more flags had to work harder on their resubmissions and had lengthier and probably more intense interactions with supervisors, while banks that received no flags in principle had no further interactions with supervisors.

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Figure 1: Simplified illustration of one quality assurance cycle under the constrained bottom-up approach.

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