Elderfield urges stress test rethink

The European Banking Authority (EBA) should change the design of its next set of bank stress tests, due in 2013, away from simply being a capital shortfall calculation, the body's alternate chairman said today.

The EBA, made up of financial regulators from the European Union's 27 member countries, is completing this year's stress test which obliged 31 lenders to plug a €115 billion hole to bring their core capital level up to 9 per cent of risk weighted assets by the end of June.

A senior source told Reuters last week that regulators may extend the scope of next year's tests to check whether business models are too risky or vulnerable and alternate chair Matthew Elderfield said it would be sensible for regulators to recalibrate their overall approach in 2013.

Speaking at a conference organised by German chancellor Angela Merkel's conservative party, the head of financial regulation at the Central Bank said the EBA could revisit make-up of the capital buffer but signalled that this would not be done before greater clarity is brought to the euro zone debt crisis.

"I would like to see that we use this breathing space wisely to consider the future design of stress tests and the operational flexibility of firewall structures. It seems that the role of the stress test as a diagnostic tool needs to be reasserted," Mr Elderfield said in a speech.

"Indeed, if this (the building of an adequate financial firewall in the euro zone) does happen and has a sustained positive impact, it could eventually give scope to the EBA to revisit the necessity for the full scale of the current capital buffer."

Mr Elderfield said that with looming Basel III rules already set to gradually require banks to hold greater capital buffers, stress testing could revert to its original brief of providing the basis for management and supervisory judgment, rather than as an automatic capital formula.

The former head of financial regulation in Bermuda cautioned against using a vast amount of money to convince markets that Europe's problems had been solved if that forced countries with debt concerns to borrow more to recapitalise their banks.

"For countries with debt problems, they need to borrow more to afford the ammunition for the bazooka and their debt sustainability position gets worse. The room for manoeuvre for ever tougher capital standards is therefore constrained," Mr Elderfield said.

"Thus, while the debate around firewall structures is normally about the sensitive issue of size, I would suggest that having sufficient operational flexibility in any new mechanism is an equally important objective.

"Finding mechanisms for investment in banking systems without adding to sovereign debt must surely be a desirable policy goal to be considered carefully. This might be done through European firewall mechanisms or other structures."

Reuters