EU-wide stress testing exercise 2010
The exercise has used commonly agreed macro-economic scenarios (benchmark and adverse) for 2010 and 2011, developed in close cooperation with the European Central Bank (ECB).
The stress test exercise includes two adverse scenarios. Both scenarios foresee an EU-wide demand shock consisting of a decrease in GDP growth, on average, by 3 percentage points cumulated over 2010 and 2011. In the first adverse scenario, the yield curve flattens as a result of an increase of 125 basis points in the short-term interest rates, accompanied by an increase of 75 basis points in the long-term rates. In the second, more adverse scenario, designed to capture the deterioration observed in financial markets since May 2010, a sovereign risk shock that incorporates a widening of average government bond spreads (compared to German government bond yields) in addition to a proportional increase in average government bond spreads (to German government bond yields) of 30 basis points has been assumed.
The impact of these adverse scenarios on banks’ Tier 1 capital ratios has been determined by using ECB provided probability of default figures and loss given default figures for different EU countries, distinguishing between assets issued by credit institutions, the corporate and the retail sector.
The initial scope of the exercise has been extended to include not only the largest EU cross-border banking groups at the consolidated level, but also key domestic credit institutions in Europe. Given its role in financial stability and given the importance of the Luxembourg financial sector, the Banque centrale du Luxembourg has included two major domestic banks, relevant for the domestic economy, on the list of institutions covered by the exercise.
The exercise required the estimation of several internal parameters including the sensitivity of profits and impaired loans to changes in GDP and other macroeconomic parameters. Without deviating from the rules of the common scenarios and key assumptions as agreed upon at the EU level, the Banque centrale has aligned the probability of default for Luxembourg to the average of its three neighbouring countries. Furthermore, based on relative changes in risk weighted assets, the Banque centrale endorses the Tier 1 capital ratios as published by the two domestic banks which, under the most severe sovereign risk scenario, remain comfortably above 6%, the benchmark determined solely for the purpose of this exercise.