On July 5, 2024, the European Banking Authority (EBA) published for consultation the draft methodology, models and guidelines for the 2025 European-wide stress test.[1] It will be coordinated by the EBA, working in cooperation with the European Systemic Risk Board (ESRB), the relevant authorities, including the Single Supervisory Mechanism (SSM), and the European Central Bank (ECB).
The EU-wide stress test is designed to provide a common analytical approach to assess the stability of EU banks and the banking system as a whole when they are subjected to economic stress, challenging their capital adequacy. The EBA Board of Supervisors is to finalise the scenarios, methodologies, quality assurance practices, models and guidelines, in coordination with the ESRB and the ECB, that will develop the adverse macroeconomic scenario and associated risk parameters.
Key objectives
The primary objective of the stress test is to ensure the robustness of EU banks by simulating adverse economic scenarios and assessing their impact on banks’ capital adequacy. This exercise also seeks to challenge the capital positions of banks and confirm that they can withstand economic shocks. To achieve this, the stress test encompasses several key aspects. First, it includes a representative sample of EU banks selected based on their systemic importance and balance sheet size. The test covers both individual banks and consolidated groups, encompassing all significant entities within the banking group. It includes both a baseline and an adverse scenario, developed in cooperation with the ESRB and the European Central Bank (ECB), reflecting potential economic and financial market conditions over the test horizon. The stress test spans a three-year horizon from 2025 to 2027, with the reference date set at the end of 2024, and applies the regulatory framework in force as of 31 December 2024, incorporating anticipated changes in regulations.
Methodology
The methodological framework of the 2025 EU-wide stress test is structured around several key components. The exercise follows a constrained bottom-up approach, where banks use their internal models to project the impact of defined scenarios, subject to strict regulatory constraints and thorough review by competent authorities. The test focuses on credit risk, market risk, counterparty credit risk (CCR), and operational risk. Additionally, it assesses the impact on net interest income (NII) and capital items not covered by other risk types. Banks are required to assume a static balance sheet throughout the stress test horizon, meaning no changes in the composition of assets and liabilities are allowed due to management actions.
A number of important changes are also introduced, notably the incorporation of the forthcoming Capital Requirements Regulation (CRR3), which is scheduled to be implemented on 1 January 2025. The introduction of CRR3 into the methodology means that the risk exposure amount (REA) will have to be restated for risk areas, while the output floor will be calculated on the total REA. Other improvements include the centralisation of NII projections and advances in the market risk methodology to increase risk sensitivity. Proportionality will also be emphasised for smaller and less complex banks in order to promote efficiency and transparency: instead of a single capital threshold, banks will be assessed on the basis of the relevant regulatory capital ratios under a static balance sheet assumption; the results of the stress tests will play a crucial role in informing the SREP, thereby influencing banks’ capital resource decisions and future capital planning.
The preliminary methodology and models proposed by the EBA are open for informal discussion with banks to allow them to receive input that will be taken into account in finalising these documents. Annex I of the methodological note contains a preliminary list of institutions included in the sample.
Assessed Elements
Credit risk assessment is a critical component of the stress test. The methodology includes all assets subject to amortized cost and fair value measurement, excluding CCR exposures. The credit risk methodology prescribes specific assumptions for projecting credit risk parameters, including the probability of default (PD) and loss given default (LGD), under the stress scenarios. The impact on profit and loss (P&L) is assessed by estimating the expected credit losses over the stress test horizon, considering both performing and non-performing exposures.
The market risk component of the stress test involves assessing all positions subject to fair value measurement, such as trading book assets and liabilities, as well as CCR and credit valuation adjustment (CVA) exposures. Banks are required to perform a full revaluation of their positions under the adverse scenario, accounting for changes in market risk factors such as interest rates, credit spreads, and equity prices. The framework ensures proportionality, allowing smaller banks and those with less complex risk profiles to apply simplified methodologies.
Operational risk, including conduct risk, is another essential aspect of the stress test. This component considers both historical loss data and projections of future losses under adverse conditions. The impact of operational risk losses on banks’ capital adequacy is evaluated, with specific constraints applied to ensure consistency and comparability across banks.
The assessment of non-interest income, expenses, and capital includes the projection of NII under the stress scenarios, considering the impact of changing interest rates and other market conditions on interest-bearing assets and liabilities. The stress test evaluates the impact on banks’ capital ratios, including Common Equity Tier 1 (CET1), Tier 1, and total capital ratios, as well as the leverage ratio. Projections are made on both a transitional and fully loaded basis.
Next steps
In conclusion, the EBA’s 2025 EU-wide stress test provides a rigorous and comprehensive assessment of the resilience of EU banks to adverse economic conditions. EBA has focused on aligning the process with the needs of banks and supervisors, considering adjusting the submission dates and the banks’ FAQ process to reflect the transition to CRR3. EBA plans to publish the final methodology at the end of 2024, launch the exercise in January 2025 and publish the results by the end of July 2025.
It is now the responsibility of the banks to assess the effects on their current stress test data and infrastructure. The incorporation of CRR3 into the computation of Risk Exposure Amounts by the end of 2024 could provide a difficulty for some banks, akin to the adjustment mandated in the 2018 stress test for the initial implementation of IFRS 9.[2] It is therefore crucial to include CRR3 implementation projects in the examination of the proposed methodology and planning of the 2025 exercise.
References
- European Banking Authority (July 2024). “2025 EU-Wide Stress Test.” (EBA) Available at: https://www.eba.europa.eu/sites/default/files/2024-07/3bd993e0-8678-40ac-9fba-9b8a6bf03f44/2025%20EU-wide%20stress%20test%20-%20Methodological%20Note.pdf. ↑
- Bank of England (December 2016). “Clarification on IFRS 9 for 2017 ICAAP stress testing and capital planning.” Available at: https://www.bankofengland.co.uk/news/2016/december/clarification-on-ifrs-9-for-2017-icaap-stress-testing-and-capital-planning. ↑
