Geopolitical Stress

The ECB and EBA begin their first explicitly Geopolitical Stress Test

Stress Test launch

The 2025 EU-wide Stress Test kicked off this month. First launched during the global financial crisis, regular stress tests have now become a permanent feature of the European regulatory landscape. The European Banking Authority (EBA) now conducts its stress test every 2 years. The test requires a sample of banks to model and project their balance sheets under a baseline and adverse scenario, and so to quantify how much their capital would decline in the event of an economic shock.

Each odd-numbered year EBA applies the test to a sample of European banks (this year it will cover 68 banks from the EU and Norway, accounting for 75% of European banking assets). The ECB, which plays a central role in scrutinising the figures banks submit, also extends the test to virtually all the Eurozone banks under its direct supervision. (The ECB also conducts its own stress tests just on Eurozone banks in even0nubered years, usually with a narrower focus, such as banks’ exposure to climate risk (2022) or ability to withstand a cyber attack (2024))

Stress testing is a key part of the ECB’s supervisory approach, and is its most important ‘forward-looking’ supervisory tool. Now that many legacy issues from the early years of ECB supervision (e.g. high levels of non-performing loans) have largely been addressed (see here), the ECB is increasingly turning its attention to potential future risks and vulnerabilities. (For example the latest SSM Supervisory Priorities in the field of credit risk promised scrutiny of banks’ ability to spot early warning signs that borrowers may not be able to repay their loans.) That suggests that the importance of stress testing as a supervisory tool will only grow.

Geopolitical shock

In a joint blog post marking the launch of the 2025 Stress Test, ECB Vice-President Luis de Guindos and Supervisory Board Vice-Chair Frank Elderson explained that this year’s exercise will be based on an imagine geopolitical shock. So this is the first big supervisory exercise we have seen in which the ECB has made its recent rhetorical focus on geopolitical risk into concrete reality.

What this means in practice is that the adverse scenario banks must model for the stress test includes not just a steep fall in GDP but also a severe reduction in global trade and a rise in energy prices - imagined as the result of some (unspecified) geopolitical crisis or conflict. As a result the effect of the imagined recession is taken to vary across industry sectors, with energy-intensive manufacturers (presumably exposed both to the trade and the energy shock) hardest hit. Banks will therefore need to model the impact of a rise in credit defaults from borrowers in this sector in particular. At the same time they must calculate losses from a sharp fall in stock prices (in particular US equities: the ECB’s November 2024 Financial Stability Review highlighted ‘stretched valuations’ in equity markets as an important risk).

The stress test thus illustrates some of the ways that the ECB will expect banks to think about their exposure to geopolitical risk. And in their blog post, Elderson and de Guindos write that supervisors will use the exercise to assess banks’ capacity to model and analyse different potential scenarios. But the stress test does not cover the entirety of the ECB’s framework for understanding geopolitical risk (as unveiled by Supervisory Board Chair Claudia Buch last September and which I discussed in this post). It does not require banks to consider how a given geopolitical shock could feed through to financial markets and the real economy, or how government policy responses could mitigate the impact of a crisis. (Instead, the ‘macro-financial’ effect of the shock are simply given as the stress test scenario inputs.) Nor does it include the potential for a conflict or crisis to disrupt banks’ operations (e.g. through physical or cyber attacks on bank staff or facilities) or business models (e.g. through the impact of sanctions). That is not intended as a criticism of the stress test, given its purpose is to understand the capital impact of a given scenario. But in other geopolitical scenario analyses the ECB may well expect banks to consider a broader range of factors.

Tackling Over-optimism

Elderson and de Guindos also warned that the stress test process would be made tougher this year. In every stress test banks are incentivised to produce optimistic projections, adjusting their model paramaters and assumptions to minimise their projected losses and hence the impact on their capital. This can both reduce their capital buffers (the ECB uses stress test results to calibrate its Pillar 2 capital guidance) and improve market perceptions of a bank’s business. To push against this supervisors scrutinise banks’ stress test submissions in great detail, challenging their assumptions and modelling approaches.

Yet despite this intensive quality assurance, Elderson and de Guindos wrote that some banks are still submitting overly optimistic projections. To make this harder, the ECB will toughen the stress test process by not sharing its internal benchmarks for credit risk parameters - key inputs for calculating likely losses - until after banks have submitted their balance sheet data. The ECB will also subject banks suspected of excessive optimism to additional scrutiny during the stress test, and may conduct on-site inspections at those firms after the test is complete to examine ‘structural weaknesses in their stress testing capabilities’.

RDARR Screen

Finally, the blog reminds banks that stress test submissions now fall within the scope of the ECB’s expectations on risk data aggregation and risk reporting (RDARR), as set out in its May 2024 RDARR Guide. Improving banks’ data quality and governance is a long-standing ECB goal - and it was a key element of the ECB’s strategic objective to tackle persistent deficiencies announced in the latest Supervisory Priorities. Elderson and de Guindos reiterated that the ECB will use its full ‘escalation ladder’ of enforcement tools (a favourite topic of Elderson’s) if banks do not improve.

With the Programme

The latest stress test thus aligns closely with the ECB’s wider priorities. It is explicitly geopolitical, reflecting supervisors preoccupation with geopolitics as a source of risk. And it comes with extra measures to make banks address past weaknesses - and tough talk about enforcement if they do not. Banks may have increased their capital and cleaned up their balance sheets - but the ECB is not backing off.