A comment on recent European Banking Authority (EBA) stress testing exercise.

β€œThe obscure we always see sooner or later; the obvious always seems to take a little longer – Edward R Murrow”

On July 28, 2023, the European Central Bank (ECB) released the results the outcomes of its most recent stress testing exercise. The comprehensive results can be accessed through this link: (https://www.eba.europa.eu/eba-publishes-results-its-2023-eu-wide-stress-test). Preceding this report, a month earlier, the Federal Reserve Board disclosed its stress test findings, noteworthy for their exclusion of smaller banks[1]. The detailed findings can be explored here: (https://www.federalreserve.gov/publications/files/2023-dfast-results-20230628.pdf).

A central theme emerging from these assessments underscores the resilience of the banking system, showcasing ample equity capital buffers to effectively navigate unforeseen financial shocks. This comes as a timely reassurance for investors, considering recent bank failures witnessed both in the United States and Europe. In simpler terms, due to these findings, and assuming other factors remain constant, we can expect a reduction in systematic risk as indicated by bank “betas”[2]. Given its significance, there arises a need for enhanced transparency, particularly in times of heightened uncertainty surrounding the financial stability of banks.

While stress testing involves intricate quantitative models and rigorous data analysis, it’s equally imperative to recognize the pivotal role of judgment at various stages of this process. Beyond the inherent biases associated with model development and its underlying assumptions, other biases also warrant explicit attention. These include:

  • Cognitive / Confirmation Bias: Managers may gravitate toward information that aligns with their preexisting beliefs, demonstrating overconfidence and an inclination to anchor decisions based on initial information. These biases significantly influence decision-making and, consequently, the outcomes of stress testing.
  • Self-Enhancement Bias: Managers often have a vested interest in presenting their decisions and strategies in an optimistic light. This self-enhancement bias can lead to overly positive evaluations of potential outcomes.
  • Social Desirability Bias: Managers might opt for decisions that align with the organization’s culture or are perceived as socially desirable. Such decisions may not necessarily be the most optimal for the business.
  • Groupthink: In collaborative settings where managers collectively make decisions, groupthink can emerge. This phenomenon involves prioritizing consensus and harmony at the expense of critically evaluating alternative viewpoints and potential risks.
  • Overreliance on Experience: While experience undoubtedly holds value, relying too heavily on past experiences without accounting for new information or changing circumstances can introduce biases.

It would be valuable for stress test results to be accompanied by a discussion that addresses the above biases more comprehensively and outlines the strategies employed to mitigate potential risks that could undermine the credibility of stress tests results.

For further information please contact: Laurie Antioch, Chief Finance & Strategy Officer, Aerapass Ltd

[1] Given the liquidity challenges these banks are facing.

[2] The value information provided by stress tests depends on financial circumstances prevailing at the time. During a crisis, the need for credible information is likely to be greater than during calmer periods.