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On the White Board - August 2010
Aug 15, 2010
European Bank Stress Tests and Investment Portfolios
On July 23, the Committee of European Banking Supervisors (CEBS) released the results of a stress testing exercise on 91 European banks. This exercise was similar in nature to the stress test on US banks performed in early 2009. In both cases, the stress tests began with the identification of two macroeconomic scenarios, one broadly conforming with the consensus expectations for the next two years, and the other representing an adverse scenario over the same timeframe
At the highest level, the banking supervisors have specified these macroeconomic scenarios through a very small number of variables (e.g. GDP growth, unemployment and housing prices). This sets a common macroeconomic severity for all banks subject to the test, but it is the responsibility of the banks and their supervisors to translate these high level specifications to losses for the individual banks. Part of this translation exercise is to specify the moves in market rates and prices that would be expected to accompany the stated macroeconomic scenarios. It is at this step that many efforts to conduct macroeconomic stress tests get stuck. While CEBS has not provided a model – a link between any macroeconomic scenario and its expected accompanying market shocks – it has made explicit the market shocks that accompany its consensus and adverse macroeconomic scenarios. We thus have now at our disposal two interesting market shocks to apply to any investment portfolio, permitting us to ask the question "what happens to my holdings in the scenario that drives seven European bank Tier 1 capital ratios under 6%?"
There is a second aspect to the translation exercise: the translation of the macroeconomic shocks (and accompanying market ones) to a bank's balance sheet or an investment portfolio's return. For the banks, this is arguably the more challenging part of the endeavor. In part, this involves specifying loss rates on banking activities, which clearly depend on regional and strategic differences between banks, not just on the movement in benchmark market rates. More importantly, translating the shocks to the balance sheet involves assumptions about time – the horizon over which the shocks take place and the profitability of the bank over that time.
For most investment portfolios, there are few of the idiosyncrasies that drive issues such as banking loss rates. This leaves us with the issue of time, which leads as well to the issue of reinvestment. As interest rates rise or equity prices fall, an investment portfolio may suffer mark-to-market losses, but also may realize losses in order to take advantage of higher market yields. In general, it is not just the size of the macroeconomic shock that determines its impact on an investment portfolio, but the path of the shock and the path of the portfolio as well.
One simple exception is where we assume that the portfolio is constantly rebalanced to maintain its relative positions; three-year bonds remain three-year bonds, for instance, rather than rolling toward maturity. From a purely mechanical point of view, we may then calculate the portfolio market value at the end of the shock by applying the shock to the existing portfolio as if it were instantaneous. (This may seem somewhat of a philosophical point, but it is important to note that we do not in fact assert that the shocks are instantaneous, but merely that we can perform the stress test mechanics as if they were.) In the end, we have a simple mechanism to apply the macroeconomic shocks, and assess their impact on investment portfolios without going through the details of a reinvestment policy. Refinements, in particular the yields available for reinvestments during the stress period, are certainly possible, but we have an initial view of portfolio performance under the European macroeconomic shocks.