Over the next few months, central banking authorities around Europe will be focused on administering the latest in a series of stress tests on the European Union (EU) banking system. This will be the fourth such exercise since 2009 and the height of the global financial services crisis. On each occasion we have seen the level of testing extended both in terms of reach and adverse scenarios.

This year, the European Banking Authority (EBA) has identified a sample of 124 EU banks to be included in the 2014 stress testing exercise. This sample has been selected to cover at least 50% of each national banking sector. The number of entities involved is a significant increase on the sample of 22 major European cross-border institutions that took part in the EBA’s 2009 stress test, though those were said to represent 60% of the total assets of the EU banking sector on a consolidated basis at that time.

In April, the EBA published the methodology and key scenarios they will be using in the upcoming stress tests. While in 2009 the EBA was focused on a two-year horizon, this time they plan to look at three years, from 2014 to 2016. They also envisage more severe adverse scenarios than were considered in the 2011 tests, including increased global bond yields, deterioration in credit quality, foreign exchange shocks and stalled policy reforms, which would test banks’ ability to exceed the adverse scenario core tier 1 ratio hurdle of 5.5%.

The tests themselves will be administered by the national competent authorities (CAs), typically the central banks, who may also include additional test elements beyond the common EU-wide methodology. The EBA will provide pan-European benchmarks and will facilitate the final dissemination of the findings.

The exact timing of the exercise may differ slightly from country to country. In anticipation however, European banks have already started taking measures to minimize the chances of their not passing the tests.

A similar exercise—the Comprehensive Capital Analysis and Review (CCAR)—conducted in the U.S. on 30 banks resulted in the U.S. Federal Reserve announcing its withholding approval of five of the participating bank holding companies’ capital plans. This result, which surprised several industry observers, will no doubt spur several European banks to take steps to strengthen their balance sheets—increasing provisions, ridding themselves of non-core activities and reducing exposure to risky loans through the establishment of “bad banks.”

Previous rounds of testing resulted in an industry that is ultimately stronger and better able to withstand potential threats—with consolidation of weaker players and an overall increase in core Tier 1 capital.  National CAs have yet to weigh in on what they will require from their domestic banks. It is the domestic regulatory requirements that may greatly impact individual banks’ competitiveness in the EU and global banking markets going forward.

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