The pandemic forced the suspension of the EBA stress test exercise planned for 2020. But, with the publication of its macroeconomic scenarios on Jan. 29, 2021, the EBA officially launched the 2021 stress test. Participating banks, 50 in total, will submit to the EBA the required information in April, May, June, and July, and the EBA will release the final results by July 31, 2021. Following the end of the post-Brexit transition period, U.K. banks will be excluded from the exercise for the first time, although the Bank of England (BoE) continues to perform its own stress tests (see "U.K. Bank Rating Actions Won’t Wait For The Bank of England’s 2021 Stress Test Results," published Jan. 20, 2021).

As usual, we will closely watch the results of the stress test exercise once published. Stress test are not only a useful tool for supervisors in their monitoring of banks, but also a valuable piece of additional information that helps market participants (including S&P Global Ratings) to form and compare views.

The ultimate goal of the test is to assess EU banks' resilience to adverse economic developments; in particular, the resilience of banks' capital. But it will also provide information on banks' expected evolution under a base-case scenario, which will be of particular interest now given the uncertainty surrounding the pandemic's full impact on the quality of banks' loan books, additional provisioning needs, profitability prospects in an environment of ultra-low rates, and banks' ability to build up capital organically--or at least preserve it. We will track all these factors closely through 2021, since their evolution is key to the fates of many European banks' ratings.

We rate 44 of the 50 European banks that will participate in the exercise (see table below). The sample selected by the EBA is distributed across 15 countries and represents about 70% of banking assets. Of the 44 banks we rate, 25 currently carry negative outlooks. At the onset of the pandemic, we affirmed almost all ratings on European banks as we expected them to be resilient to the unexpected COVID-19 shock, but we revised a number of outlooks to negative on account of increased downside risk; in particular, the potential for a harsher economic environment or a more significant impact on bank's credit performance, capital, or profitability. Despite a handful of outlook revisions to stable in recent weeks, the proportion of European banks with negative outlooks remains higher than in other regions. Throughout 2020, banks' regulatory capitalization was largely preserved, helped by supportive regulatory measures such as the Capital Requirements Regulation "quick fix" package and the suspension of shareholder distributions, but profitability sank and the prospects remain lackluster, even once impairments decline in 2022.

Table 1

Table 2

The desktop vulnerability exercise performed by the European Central Bank (ECB) in mid-2020 (see "The ECB Takes Comfort In Likely Eurozone Bank Resilience," July 29, 2020), which concentrated on 2020-2022, already highlighted banks' vulnerability to a weaker environment, with banks depleting capital and reporting losses in both the base and adverse cases. Furthermore, a quarter of banks were expected to fare far worse than the average, resulting in capitalization levels under the adverse scenario, which would cause concern. The message will probably not be different this time around, but results will be disclosed individually for each bank participating, which will provide further insights on which banks have more stretched capital positions, and which ones could have more profitability and business model challenges to tackle.

A Harsh Adverse Scenario

The baseline scenario to be considered in the exercise reflects the expectations provided by the national central banks and point to a three-year cumulative expansion of economic activity of almost 11% in the EU, which is fairly aligned with what we expect. The timing of the rebound is slightly different, with the EBA GDP forecasts being somewhat more cautious for 2021, probably due to the latest pandemic developments. By country, we have differences in both directions, but these are not very significant (see chart 1).

Chart 1

The adverse scenario is a harsh one that assumes European economies would remain in recession for at least 2021 and 2022, if not during the three years covered by the exercise. The persistence of the pandemic and weak confidence would explain the protracted economic contraction and higher unemployment, which would also lead to a sharp correction in financial and real estate markets. In the adverse scenario, the EBA contemplates a cumulative decline of GDP in the EU of -3.6%, compared with a growth of almost 11% in the base case, which would come on top of the -6.9% contraction forecast for 2020. Unemployment would increase by 4.7 percentage points. Residential real estate prices would decline by 16% and commercial real estate prices by 31%, although there will be marked differences by country. Risk premia would also increase and differences in the eurozone countries would widen. European stocks would lose half of their value in the first year.

In this environment, the calibration of adverse scenarios is more difficult than usual, as there is uncertainty on the long-term path of post-COVID-19 economies and their ability to recover quickly in the medium term. That may explain why the adverse scenario defined by the EBA and the one announced by the BoE on Jan. 20, 2021, differ considerably on the pandemic's effect on economic activity in the years to come. While the EBA's adverse scenario depicts a sideways drift, the BoE assumes a massive shock in 2021 and a subsequent recovery. Assumptions on peak to trough decline of residential housing prices also appeared tougher in the BoE stress test.

As vaccine rollouts in several countries continue, S&P Global Ratings believes there remains a high degree of uncertainty about the evolution of the coronavirus pandemic and its economic effects. Widespread immunization, which certain countries might achieve by midyear, will help pave the way for a return to more normal levels of social and economic activity. We use this assumption about vaccine timing in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

The Stress Test Will Inform Regulatory Decisions

Similar to previous stress tests, the exercise will show the expected evolution of banks' capitalization under both the base and adverse case, providing a measure of the sensitivity of banks' capital to negative macroeconomic developments. The focus will be on CET1 capital, calculated both on a transitional and fully loaded basis, although Tier 1 capital, total capital ratio, and the leverage ratio will also be disclosed.

The outcome of the exercise will inform regulatory decisions. As in the past, it will be used as an input for regulatory authorities to set up banks' supervisory review and evaluation process (SREP) requirements, but it could equally be used to have a more tailor-made approach to dividend distribution. As in the past, we expect any decisions to increase SREP requirements following the results of the stress test to affect banks' Pillar 2 guidance rather than Pillar 2 requirement. Therefore, they would not increase the risk of banks facing mandatory restrictions of coupon payments on hybrids.

Interestingly, the EBA also indicated that the outcome of the exercise may help to inform authorities' future decisions with regard to the withdrawal of the flexibility measures granted to help banks navigate through the pandemic, or on the need to take additional measures should the economic conditions deteriorate further.

As in the previous two stress test exercises, there will be no formal pass or fail capital threshold, and therefore no predetermined route to follow. But authorities would likely pay close attention to institutions that performed weakly in the exercise, and would require those institutions to take action.

Little Change To The Methodology

The methodology, disclosed in November 2020, is very much in line with that applied in the two previous stress test rounds in 2018 and 2016. It maintains assumptions which would be unlikely to hold true in reality--for example, the static balance sheet-- but which, in our view, facilitate comparisons and the diagnosis of each bank's starting point and potential vulnerabilities. Other assumptions that banks should consider in the exercise include the following: no workout or cure of Stage 3 exposures; no release of Stage 3 provisions; no decline in the aggregate coverage of Stage 1 credits; no rollout of new internal models or modifications of existing internal models; and no credit to divestments or other capital measures not completed before the end of December 2020.

We will closely monitor banks' disclosures around the expected migration of credits across International Financial Reporting Standards (IFRS) 9 stages, including the reclassification of loans under moratoria to the appropriate stage bucket on Jan. 1, 2021 (as the assumption of the exercise is that COVID-19 moratoria will not be in place on day one).

Related Research

• U.K. Bank Rating Actions Won’t Wait For The Bank of England’s 2021 Stress Test Results, Jan. 20, 2021
• European Economic Snapshots: Policy Is Keeping The Impact Of The Second COVID Wave At Bay, Dec. 16, 2020
• Credit Conditions Europe: Waiting For Relief, Dec. 3, 2020
• 2018 EU Bank Stress Test: Harsher Macro Assumptions And IFRS 9 Will Raise The Bar For Some Banks, Oct. 31, 2018