What will the 2025 European stress tests show?

– The geopolitical risks, no doubt.

In January, the EBA announced stress tests in the European banking sector with a stress scenario where, among other things, worsening geopolitical tensions lead to a 6.3% decline in GDP over a space of three years. Are we living under a volcano?

– Stress-testing should be viewed as an instrument of the European Union’s supervisory authorities, including national authorities, designed to assess the resilience of individual banks and, as a consequence, of the banking system to risks, and especially to the extreme risks that take the form of severe shocks. These exercises make it easier to detect poorly identified risk areas within banks. On the basis of these tests, the appropriate supervisory steps should be taken. The exercise is also important for the banks themselves, since it gives them a better understanding of the risks. We identify risks individually for each bank. This year, the exercise directly tests 64 institutions. We disclose the performance of each bank, which increases market transparency and improves communication between the supervisory authorities tasked with micro-prudential and macro-prudential supervision and resolution authorities. The results of such stress-testing show the effect a shock would have in terms of the depletion of capital, that is the CET 1 ratio, and they form the basis for supervisory recommendations relevant to the Tier 2 capital requirements.

What has emerged from previous test exercises?

– All the previous test exercises have made it clear that even in the face of the most severe scenario, the CET 1 capital to risk-weighted asset ratios have remained comfortably above 10%, even though the scenarios adopted in the successive testing rounds were generally ever more demanding, or at least the degree of their severity remained unchanged.

To what did the banks owe this resilience?

– During the good times, banks in Europe managed to solve the problem of non-performing loans (NPLs). Interest rates were very low, there was a lot of money in the market and investors were looking for yields – this helped banks sell a large proportion of such portfolios. The banks improved the quality of their balance sheets and, in parallel, consistently increased their capital levels. For instance, in 2014, the average CET 1 ratio was 12.5%, and has now risen to around 16%.

Do we still face risks associated with the too-big-to-fail banks, whose bailouts during the great global financial crisis consumed huge amounts of public funds and drove entire countries into bankruptcy?

– This is a broader issue that goes beyond that of stress testing, but the tests obviously give us some idea of which group of banks is more vulnerable. A crucial role here is played by actions based on the Bank Resolution and Recovery Directive (BRRD), which allow banks to fail and make us aware that they are exposed to potential disruptions in their operation, which cannot, however, turn into system-wide disruptions. Moreover, the costs of the recovery or resolution of such failing entities cannot now be transferred to the taxpayer, as was the case during the great financial crisis, but must be distributed primarily among the shareholders and holders of subordinated and unsecured debt. The protection of deposits remains a kind of Hippocratic oath for bankers.

Does the EBA also intend to test banks to see whether they can undergo resolution without disruptions?

– One of the tools that make banks resolvable, i.e. fit for resolution, is the MREL requirement, which we also check banks for. The latest review has shown that all of the 39 banks that are intended for resolution in the EU comply with the MREL requirements as of 1 January 2024, with the exception of 21 banks in a transitional period. The EBA keeps refining the tests and aims to extend them in the future with a view to testing banks for operationalisation or resolution planning possibilities, as a key means of improving their ability to undergo resolution if need be, and to improve preparedness for the resulting crisis management. It is therefore a high priority for the Agency to work on the creation of guidelines for supervisory authorities and institutions that would foster the dissemination of best practices in this area.

Work is under way to improve crisis management capacities in the European Union, which will be ensured by the CMDI package, and we are looking forward to its swift adoption and to the finalisation of the Banking Union, which is at a political standstill due to controversies regarding the common deposit guarantee scheme. It is important to remember that the problem of ‘too-big-to-fail’ banks should also be considered in relation to the US, where banks are much larger than in the EU. The competitiveness of the European economy vis-à-vis the US and China has been increasing in recent years, particularly intensely in recent months. As far as US banking is concerned, US competitors are bigger. This means that they are able to support companies’ investment in technological transformation and other improvements, such as artificial intelligence, and they are in a better position to finance investments that are beyond the reach of European banks.

Until recently, jurisdictions have been fairly consistent in implementing the regulations proposed by the Basel Committee on Banking Supervision. Now, we have a situation where some countries are suggesting that they will not put them in place or even relax them. How should European regulators approach this situation?

– This is also an area vulnerable to geopolitical risks given the announcements made by the Americans and signals from the UK that the finalisation of the Basel package will be delayed or waived. The announcement by the Commission of a delay in the adoption of the market risk package (Fundamental Review of the Trading Book – FRTB) makes it clear that the European Union is actively responding to such signals. Nonetheless, nervous responses should be avoided, because the declarations made by the US are very compulsive, unexpected and sudden, and we must remember that this kind of race to loosen the rules can end disastrously for the global financial system, as has been evidenced by recent history. Such a unilateral relaxation may have two effects. It may be a gamble designed to increase competitiveness in the short term in the US jurisdiction, which has been rapidly relaxing the requirements, but it may also trigger a crisis in it and increase the risk of contagion, to which a jurisdiction with stricter rules, like the European one, should be immune.

The cold-blooded behaviour on the part of the European Union is exemplified by a situation during the first term of President Donald Trump, when US regional banks were actually exempted from the Basel interest rate risk management requirements. The EBA is to be highly commended for having acted very astutely in doing just the opposite and adopting a comprehensive package designed to manage interest rate risk in the banking book (IRRBB) and credit spread risk over a space of three years, which was finalised after 2021. The legislation tightened considerably the interest rate resilience testing requirements. The interest rate risk turned out to be the trigger of the collapse of US banks in March 2023, and the shock this unleashed around the world hit, for example, Swiss banks, but the banking system in Europe proved immune to this shock wave. The reaction on our part was very calm and opposite to the US policy, so now it is important that we keep a cool head when dealing, in particular, with an unpredictable partner, as the US has become.

That is to say, adjust rather than relax?

– This is a question of managing the risk within the existing regulatory framework. On the one hand, we have the issue of the possible regulatory response or regulatory adjustments to what the big global jurisdictions (the US, the UK) are doing, but also countries in the Far East, the Asia-Pacific region, which are also major players. As an aside, Japan, for example, has rolled out the Basel package consistently, as has Europe. On the other hand, it is necessary to treat the relaxation trend as a materialisation of geopolitical risks. When the dust settles, it is important to consider to what extent the US will delay or relax the regulation, and what secondary effects this may have if the relaxation sparks a crisis there. There is another aspect of this risk, namely the attempts by the new administration, by the president, by his entourage (especially Elon Musk with his assertions) to influence the personnel composition and actions of the US macro-prudential monetary authorities. This, too, could have consequences, as we remember that the 2007-2008 macroeconomic imbalances unleashed a contagion effect that almost overturned economies and financial systems in the EU. This should make us monitor continuously the global risks that are a novelty on the map of risks we face.

How else has the risk environment changed since the previous stress testing exercise?

– Stress-test scenarios are tailored to ongoing developments, are prepared by colleagues from the European Systemic Risk Board in cooperation with us. The risk environment has evolved since the previous stress testing exercise. Two years ago, the tested scenarios rightly predicted that Russia’s invasion of Ukraine would last longer than it might have seemed. Thankfully, the worst-case scenarios have not materialised, but today we know that the current geopolitical risks and the associated uncertainty about the economic and market parameters, such as interest rate volatility, are bound to stay with us for longer.

The lesson we have learnt over the past two years is that the geopolitical risks are a new phenomenon and will last. In 2023, interest rates were being raised on a massive scale in Europe to respond to high inflation rates. Initially this had a positive effect on EU banks and the European Economic Area, ending a decade of reduced profitability for banks, but this is now coming to an end. We have already seen interest rate cuts, which are putting pressure on interest margins in Europe. Nevertheless, European banks still succeed in maintaining their record rate of return on equity, which is much higher than in the previous decade. They owe this, among other things, to the proper management of interest income, for instance by strict adherence to the hedging strategies.

Fee and commission revenues have also been on the rise. By contrast, credit growth continues to be an area of uncertainty. In turn, the increase in interest rates has shown exposure to interest rate risk with a devastating effect in the United States. Another challenge for the sector is posed by the fact that recent years have seen a rise in banks’ costs due to inflation. While inflation has eased, cost pressures persisted in 2024, as banks need to invest in technology and continue to employ top-class (highly-paid) specialists.

What risks are banks exposed to due to the financing environment developments? – Banks have recently had a good time window to refinance and raise funding in the market for debt-funding, acquire MREL securities, and boost their deposits, albeit with interruptions such as the collapse of Credit Suisse and the write-down of its AT1 bonds. Such developments aside, banks have been taking advantage of a good period and raising funds on a mass scale. They have withstood the discontinuation of targeted longer-term refinancing operations (TLTROs) in the euro area. On the other hand, in recent months there has been the risk associated with very high market volatility, which may cause the favourable financing environment to disappear.

And what about the quality of assets? There has been a sustained improvement. Is it reversing now? – The quality of assets in the euro area is very good, although it deteriorated slightly in the third and fourth quarters of last year. In 2023, the NPL ratio was 1.8%, rising slightly to 1.9% in 2024. There is high uncertainty about asset quality in certain areas of lending, such as commercial real estate, and there are also clear signs of deterioration in asset quality with regard to small and medium-sized enterprises, e.g. the NPL ratio increased from 4.3% to 4.6% in 2023-2024, and this is probably not the end of the declining trend. We continue to face the risk of the war expanding, and we have also seen a growth in cybersecurity incidents, which were noticeably on the rise in 2023.

Are banks in a state of cyber war?

– In the latest risk assessment questionnaires published by the EBA, banks indicated a rising threat of cyber attacks. The number of banks that suffered up to 10 cyber attacks increased annually from 30% in 2022 to 50% in 2024. The number of banks that were targeted by more than 10 cyber attacks has remained stable, at below 10%. Since 2023, the share of banks that have reported at least one successful cyber attack that qualifies as a major cybersecurity incident has increased. 24% of banks reported such an attack compared to 19% in the previous year. Last but not least, there are climate-related risks. As early as 2023, significant transition risks were identified, but the physical risks were underestimated. Meanwhile, the floods in Poland and Spain (Valencia region) have highlighted the seriousness of the materialisation of climate risks, since it exposes banks to huge losses.

What are the specific risks for Polish banks?

– I can now look at the risks faced by the Polish banking sector, which I am very familiar with, from a somewhat different, wider perspective. In the broadest terms, the risks of the Polish banking sector are very similar, if not almost identical, to those of the European sector. These include pressure on interest margins, which will have a negative impact on banks’ profitability, concerns about asset quality, cyber risks, the potential need to increase operating costs as a result of inflation, which continues to be uncontrollable, rising wages, but also the need to increase spending on IT systems. All the while, the Polish banking sector is similarly affected by the uncertainty posed by macroeconomic data and interest rates.

Polish banks have proven to be vulnerable to climate risks. However, profitability figures are still much better than for banks in the European Union. For example, the net interest margin in Poland averaged 4.4%, with net interest income contributing more to the profits of Polish banks than on average in the EU. Administrative expenses and payroll costs are on a similar level, reaching 18-19%, but Polish banks record a much higher return on capital than the 11% average in the Union, which is still an excellent result. This would be it when it comes to the sweet part of the comparisons.

And the bitter part?

– The quality of assets has been far worse for many years. In fact, it has always been so; it is a chronic disease. Is this worrying? Some people with a chronic disease can live for many years. In Poland, for example, the ratio of NPLs reached 4% in Q3 last year, an increase of 20 basis points, which means that the share of NPLs is twice as high as in the Union. But to ease the worry of the participants of the Banking Forum, the LCR in Poland is 240%, with the EU-wide ratio of 161%. Capital ratios are very high, too, and slightly better than in the European Union, amounting to 17% against 16%, which gives Polish banks a cushion to amortise the effects of risks should they materialise.

Leading analysts have a fairly positive view of the prospects of the Polish sector, which is considered attractive, even despite the major problem with frank loans, of which Forum participants are aware. Unfortunately, there are challenges specific to our sector, to which attention is drawn, too, namely the issues of WIBOR-related lawsuits and judgments of the Court of Justice of the European Union related to consumer loans.

Are the geopolitical risks hard to ignore?

– Poland is particularly strongly exposed to geopolitical risks due to it being a next-door neighbour of the Russian Federation and Belarus, and owing to increased cyber risks. While the threat of increased inflation has lessened, it has subsided slowly, and we still don’t know what the trend will be. There is also uncertainty about the level of interest rates. That said, banks appear to be well prepared to protect their net interest income in the event of a fall in rates.

Two Polish banks will participate in this year's stress tests, PKO BP and Pekao. In August, once the results have been announced, will they rejoice or despair?

– The remaining Polish banks are part of banking groups that are subject to the exercise at the consolidated level, while PKO BP and Pekao will be tested directly. Their results in previous testing rounds were positive and clearly better than for many other institutions, and in some areas even the best in the peer group. For example, in 2023, for Pekao, the decrease in CET 1 capital in the event of the negative scenario was -27 basis points, compared to -165 basis points previously, so this is a very good outcome. PKO BP was closer to the average, with a decline of 444 basis points in 2023, but this was not a value that stood out negatively against the other strong groups. 

The interview was conducted by Jacek Ramotowski

Bank.pl (Poland)