Is bank stress testing the main solution in the prevention of future bank failures?

Abstract

This study aims to investigate whether the EU-wide stress tests carried out by the EBA in 2011 could help to restore confidence in the EU banks stress tested, and in turn could reduce the probability of a crisis. Stress testing by financial regulators has been in the financial scene for some time; however, recent concepts of such an exercise were those of the publication of the results and also the testing of banks across borders. Banks in the EU started being stress tested in 2009 and subsequently in 2010 and 2011. However, as from the 2010 stress test, the EU officials responsible for stress tests decided to publish the results. The main purpose of stress tests is that of examining and assessing the resilience of banks during difficult adverse scenarios. This subject was chosen because it is a much debated topic in the financial - especially in the banking - services. It is of paramount importance for any country to have its investors assured of their money entrusted in these banks. Such a study will determine whether the stress tests can restore and improve the market participants' confidence in banks. Major areas for the EU-wide stress tests of 2011 include a consistent and predetermined capital benchmark, a common baseline and adverse scenario, and a quality assurance and peer review process.This study investigates the criteria used in conducting such stress tests of 2011 by EBA, and what actions are to be taken in the event of any bank failing the test, while at the same time, not ignoring those that have met the required criteria. Moreover, it examines any shortcomings in the stress test as an ongoing process and finally it provides recommendations and alterations so as to address any loop holes which might arise. For this, we will analyse the share price movements of banks stress tested by EBA in 2011, before and after the publication of the tests’ results.