Across the Atlantic, the European Banking Authority (EBA) and other financial regulators in the EU have conducted their own stress tests, but instead of being done by an independent regulator (like the Fed in the U.S.), European banks run their own stress tests, with the results then reviewed and approved by regulators.
Writing for VoxEU, Frederike Niepmann and Viktors Stebunovs explain the problem with this system.
In the European Banking Authority’s EU-wide stress tests, banks project capital ratios under a hypothetical adverse scenario employing their own models, which are constrained by a common methodology set by the Authority. This column argues that letting banks produce their own projections means they are prone to manipulation. It finds evidence that banks’ internal models are modified to lessen losses given the applicable scenarios and exposures. Without this manipulation, projected aggregate credit losses would have been up to 28% higher in the 2016 stress tests.
Based on changes in the models used by the banks from the 2014 to the 2016 stress tests, Niepmann and Stebunovs find a negative relationship between the change in credit losses due to changes in the scenario (given to them by regulators) and changes in the models used by the banks. These results hold even after controlling for changes in the riskiness of bank portfolios.
Though the causes of the model change are unclear, the authors offer a few different explanations.
First, we show that the banks with the larger incentives to lower credit losses through model changes (those banks that we estimate had larger increases in losses because of scenario changes) were the ones that rely more on the internal-ratings based (IRB) approach…Under the IRB approach, banks build their own models to assess credit risk in their books. The approach likely leaves a lot of room for manoeuvre so that banks can camouflage manipulation amid high complexity of models and exposures…
Second, we show that the banks that adjusted their models the most had the better performing 2014 models, meaning their 2014 models were better at predicting the observed annual loan loss reserves as a share of gross loans (our proxy for loan loss rates) from 2013 through 2016…These banks may have been under less scrutiny from supervisors. Indeed, supervisors appear to have paid more attention to the models of weaker banks.
These results are concerning, especially given that credit losses would have been 28% higher without this gamesmanship. There are plenty of criticisms to be made of American macroprudential policy and financial regulation, but putting stress tests in the hands of regulators, rather than the banks themselves, is a definite improvement over the European model.