A comparative analysis between the EU-wide stress testing framework and the Dodd-Frank act stress testing framework

Abstract

Stress testing evaluates the banking system's resilience to exogenous and endogenous economic shocks by modelling the consequences of potential economic downturns on bank profitability and financial statements. This dissertation sought to gain insight into the differences and similarities between the EU-wide stress testing framework and the Dodd-Frank Act stress testing framework. This comparative analysis exercise was done by assessing the macroeconomic scenarios used; the assumptions and models employed to convert the macroeconomic scenarios into capital ratios; and the post-stress capital thresholds selected, if any. Additionally, this dissertation highlighted the best strategies used to improve the methodologies. In this respect, after all the results of this research study were analysed, a set of recommendations were proposed, aimed at improving the quality of stress-testing exercises performed by the European Banking Authority and the Federal Reserve. Comparing the two frameworks revealed a number of commonalities and differences. Both frameworks execute macroeconomic stress testing and evaluate the implications of risk drivers on bank solvency, including credit risk, market risk and liquidity risk. Both methodologies emphasise the significance of market disclosure and transparency of results. However, the EBA employs a bottom-up approach, whereas the FR adopts a top-down approach. Moreover, unlike the DFAST, the EU-wide stress testing framework does not include a severely adverse scenario in its methodology, which means that the FR’s stress scenarios are significantly more rigorous. Furthermore, the DFAST does not envisage bank-specific impacts in its projections, rendering the results less accurate. Finally, another difference relates to the absence of choice of post-stress capital thresholds in the case of the EBA.