Introduction by the Executive Managing Director

Stress Test 2014

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Stress Test 2014

Preface Introduction by the Executive Managing Director The stress test conducted by the European Central Bank (ECB) is a hotly-debated issue, both in the banking sector and the media. Conducted alongside the Asset Quality Review, the purpose of the stress test is to strengthen the stability of and confidence in the sector before the ECB takes over surveillance for 128 euro area banks in November 2014. For the VÖB, this stress test has extraordinary importance, since no other banking association in Europe has as many member institutions that will be directly supervised by the ECB. 14 out of 24 supervised German banks are VÖB members. Much of the information about the stress test will not be published but take place only in direct communications between the European supervisory authority and the banks involved. Hence, with this brochure we would like to provide an overview of the key features of the stress test, and to answer the most important questions. Please do not hesitate to contact us directly for any further questions you may have. Yours sincerely, Prof Dr Liane Buchholz The Association of German Public Banks 3

Contents Contents 1 Facts about the stress test 6 2 Place within the Comprehensive Assessment 8 3 Participating banks 10 4 Current timeline 11 5 Criteria for passing the test 14 6 Macro-economic stress scenario 16 7 Stress test calculation 20 8 Structure of data queries 22 9 Join-up with the AQR 24 10 Re-capitalisation 25 List of Abbreviations 26 The Association of German Public Banks 5

Facts about the stress test 1 Facts about the stress test Place within the Comprehensive Assessment Participating banks Timeline 6 The Association of German Public Banks

Facts about the stress test Criteria for passing the test Base scenario: CET1 ratio of 8% Stress scenario: CET1 ratio of 5.5% Macro-economic stress scenario Stress test calculation Credit risk Market risk Securitisation risk Sovereign risk Funding & Interest Other Structure of data queries 24 tables for the EBA stress test 10 additional tables for the ECB stress test Join-up with the AQR AQR and stress test results combined in a schematic manner that can be replicated The Association of German Public Banks 7

Place within the Comprehensive Assessment 2 Place within the Comprehensive Assessment Within the framework of the Single Supervisory Mechanism (SSM), the European Central Bank (ECB) will assume supervisory responsibility for 128 euro area banking groups on 4 November 2014. In preparation, the ECB has been conducting an extensive review of the banking system since October 2013 the so-called Comprehensive Assessment. The purpose of the Comprehensive Assessment is to create transparency regarding the items carried on the balance sheets of affected banks, and to propose measurement adjustments or changes in the balance sheet positions if necessary. The goal of this exercise is to strengthen the confidence in the future European banking supervision through the prior audit of the institutions and the discovery of any hidden risks. The ECB will conclude the Comprehensive Assessment in October of this year, prior to assuming its new regulatory powers. The Comprehensive Assessment will be carried out in three stages: In accordance with the rules governing the single supervisory mechanism (EU Council regulation conferring specific tasks on the European Central 8 The Association of German Public Banks

Place within the Comprehensive Assessment Bank concerning policies relating to the prudential supervision of credit institutions the "SSM Regulation"), the ECB will carry out the Comprehensive Assessment jointly with the banking authorities of participating member states. At the same time, the ECB's stress test will be conducted in close coordination with the European Banking Authority (EBA). The EBA has been instructed to carry out an EU-wide stress test, together with the one conducted by the ECB. Both exercises take place in a coordinated manner, and largely in concert with each other. The Association of German Public Banks 9

Participating banks 3 Participating banks ECB's stress test is mandatory for all institutions which are classified as "significant" (as defined in the SSM Regulation), and will thus be directly supervised by the ECB from November 2014 onwards. The institutions to be included in the simultaneous EBA stress test must together account for at least 50% of the total assets of the entire banking sector in the respective member state. Responsible supervisory authorities may extend the sample. Accordingly, the ECB has extended its sample to include all banks falling under the SSM. 10 The Association of German Public Banks

Current timeline 4 Current timeline The Asset Quality Review has been in progress in the banks concerned since February 2014. The balance sheet review at the various institutions is expected to last until August 2014. Consultation In parallel, the EBA and the ECB provided Excel sheets to be used for data capture together with a draft of the corresponding methodology for a twoweek informal consultation period in March of this year. Given this very short timeframe, institutions were able to gain a rough overview at best. The fact that, nonetheless, final requirements were set on this basis explains quite a few of the inaccuracies and irregularities discovered over time. Publication of requirements The publication of the last remaining stress test requirements had been scheduled for 19 May 2014. Within the banks, the responsible departments plan their human resources accordingly, in order to be able to work at full speed performing the tasks and requirements placed upon them, from this very date. In the end, the publication of documentation guidelines was delayed by more than a week. Additional documents such as the benchmark parameters for sovereign risks were published only three working days before the bank s deadline to hand in the final data. Any delay of publications due will shorten the time available to institutions to work on the test a unilateral discrimination. Provision of data ECB has requested that stress test data be submitted in mid-july. However, the German regulatory authority originally moved this deadline to mid-june, in order to be able to assure the quality of data provided before forwarding it to the EBA and the ECB. Other supervisory authorities across Europe have provided their institutions with more time, and even The Association of German Public Banks 11

Current timeline the ECB itself does not anticipate forwarding the calculations to national supervisory authorities before 30 June 2014. We demand the retention of the ECB's original timeline, based upon which institutions have planned their resources for calculating the stress test. The shortening of the deadline by German regulators is a disproportionate move, places German institutions at a disadvantage compared to their European peers and was communicated too late. Responding to the criticism from the German banking sector concerning the timeline as a whole, and the unforeseen delay, German regulators have accommodated the requests put forward and have moved the submission deadline for the data to be calculated within the scope of the stress test to 23 June 2014. Quality assurance Following submission of the calculations performed in the institutions, regulatory authorities will conduct a multi-stage quality assurance. German regulators will first review the data on their own, and then in cooperation with the ECB. Once data has been forwarded to the ECB and the EBA, further quality checks and enhancements will be performed until the end of August, in close coordination with the banks concerned. The results of the ECB and EBA stress tests are scheduled for coordinated publication in October. Following the conclusion of the data capturing process, we believe the stress test results should be communicated in a carefully prepared and executed manner. Any unintentional publication of results (or parts thereof) must be avoided. 12 The Association of German Public Banks

Current timeline Date Measure 02 June 2014 06 June 2014 06/17 June 2014 23 June 2014 30 June 2014 14 July 2014 September 2014 October 2014 Preliminary data submitted to the German regulatory authority Capital planning submitted (for the case of an undercapitalisation) Benchmark parameters published Calculations submitted by institutions to the German regulatory authority Calculations forwarded by national regulatory authorities to the ECB Calculations forwarded by national regulatory authorities to the ECB and EBA End of AQR 'join-up' with the stress test Stress test results published Regulatory responsibility German regulators German regulators ECB/EBA German regulators ECB ECB/EBA ECB ECB/EBA The Association of German Public Banks 13

Criteria for passing the test 5 Criteria for passing the test The resilience of institutions is tested using two underlying scenarios: the base scenario and the adverse (stress) scenario. Whilst the base scenario is based on expected economic developments in the euro area, the adverse scenario developed by the European Systemic Risk Board (ESRB) reflects the key systemic risks the European banking sector is exposed to. The stress test is based on financial statements as of 31 December 2013. In a first step, however, these must be revalued in line with the regulations implementing the Basel III regime in the EU: the CRD IV and CRR, which only came into force on 1 January 2014. The two scenarios include the years 2014 to 2016, one year more than in the EBA stress test conducted in 2011. The test is based on the assumption of a static balance sheet, disregarding any planned business expansion or portfolio reductions. However, mandatory restructuring plans which were coordinated with the European Commission and published prior to 31 December 2013 may be taken into account. The minimum capital requirement for the base scenario has been set at 8 per cent Common Equity Tier 1 (CET1); institutions must be in compliance with this minimum at the end of 2014, 2015 and 2016. The minimum ratio for the stress scenario is 5.5 percent, and must be complied with at the end of the projected three-year period (i.e. at the end of 2016). The scenarios were provided in the form of tables listing the key economic parameters of the major economies. Institutions will implement the scenarios provided by the EBA, and will determine the impact on their specific risk measures. 14 The Association of German Public Banks

Criteria for passing the test Despite the strict criteria, the 14 VÖB member institutions are wellpositioned for the stress test. Landesbanken in particular have undertaken significant efforts in preparation for the test, to reduce the size of their balance sheets and to boost their equity ratios: they reduced their risk-weighted assets by almost 50% and now have an average capital ratio of 14.9%. Annual change in total assets and risk-weighted assets of the Landesbanken and all banks in the euro area The Association of German Public Banks 15

Macro-economic stress scenario 6 Macro-economic stress scenario The adverse scenario, as prescribed by the EBA, is based on the assumption that various systemic risks materialise: In line with these assumptions, the stress scenario developed by the ESRB implies a decline in global economic growth rates by five to six percentage points over a three-year period, compared to the assumption in the base scenario. The scenarios have been provided in the form of tables compiling key economic data for all EU member states, including simulation data for economic growth, inflation rates and unemployment, as well as prices of residential and commercial property, separately for the base and the stress scenarios. For those interested, the full details of the stress test scenarios are available under https://www.eba.europa.eu/-/eba-publishescommon-methodology-and-scenario-for-2014-eu-banks-stress-test. 16 The Association of German Public Banks

Macro-economic stress scenario Development of economic growth rates in Germany and the EU in the base and adverse scenarios Development of inflation rates in Germany and the EU in the base and adverse scenarios The Association of German Public Banks 17

Macro-economic stress scenario Development of unemployment rates in Germany and the EU in the base and adverse scenarios The stress scenario incorporates an interest rate shock, combined with financial market shocks, a collapsing emerging markets demand and a two-year recession in the euro area. In terms of scope, the macroeconomic shock incorporated into the adverse scenario is close to economic developments that were observed in the aftermath of the Lehman Brothers insolvency. However, in contrast to historical developments, economic activity as assumed in the stress scenario hardly shows any recovery in the following year. Likewise, in each of the crises observed to date, there was at least one 'safe haven' certain economies which were affected to a minor extent, relative to other economies, in the event of an economic slump. In this regard, the assumptions incorporated into the adverse scenario are more severe than one would expect, looking at historical data. Still, compared with the stress test conducted by the US Federal Reserve, the assumptions are more realistic. We believe that a tough stress test is important for building confidence and for the markets, which is why we welcome the strict scenarios. However, the scenario raises certain issues in detail, since the development of certain parameters is not understandable especially where there is no base scenario setting for a particular parameter. For instance, 18 The Association of German Public Banks

Macro-economic stress scenario the European Commission has only provided base scenario details for the years 2014 and 2015; data for 2016 will need to be estimated using various methods. Moreover, some of the assumptions regarding the robustness of individual economies are unrealistic. The scenarios for property price developments in the various countries are not always reconcilable. Discrepancy of housing price developments between the base and stress scenarios in various countries Additional irregularities become obvious when cross-referencing multiple time series. For example, the economic cross-relationships between inflation and GDP trends have been ignored in some cases. We demand that the macroeconomic scenarios for any future stress tests should be more realistic and more consistent. The Association of German Public Banks 19

Stress test calculation 7 Stress test calculation Institutions must simulate the impact of scenario data on various risk measures. Many institutions are able to use software based on their own, 'normal' planning processes to carry out the simulation. In these cases, there is no need to develop the models from scratch: they only need to be adapted in order to be able to import the data provided. Institutions which find themselves unable to implement the macroeconomic scenarios may use values provided by regulatory authorities (so-called benchmark parameters) for estimating credit risk indicators. Whilst it is possible to diverge from these benchmark parameters when implementing scenarios using own systems due to the institution's specific portfolio structure, regulators can oblige institutions to use unchanged benchmark parameters. In addition to the prescribed macroeconomic scenarios, portfolios are stressed via specific methods (for the development of certain asset classes, for example) provided by the supervisory authorities. Assumptions are made for the following types of risk, and requirements set out for the way in which stress is applied: Type of risk Credit risk Market risk Stress methodology Stressed PD and LGD, potential rating migration, and stressed IRBA parameters for risk-weighted assets Bank-specific reduction in non-trading income or revaluation based on market risk parameters, CVA haircuts, default of the largest counterparty (excluding CCPs, market infrastructure, sovereigns) Securitisation risk RWA increase depending on the risk profile, impairments in some cases in line with market risk Sovereign risk Changes in market prices, impairments due to (prescribed) rating migration 20 The Association of German Public Banks

Stress test calculation Type of risk Stress methodology Funding & Interest Sensitivity analysis for a deterioration in funding markets and in retail funding (bank's own assumptions subject to constraints) Other Haircuts for real estate funds in market risk factors, estimated impairment, estimates for other income, fixed expenses, fixed increase of operational risks The Association of German Public Banks 21

Structure of data queries 8 Structure of data queries Institutions must complete and submit the Excel sheets provided by supervisory authorities. The finalised tables, which institutions received on 17 June 2014, consist of two parts: 24 mandatory Excel tables for all banks participating in the EU-wide stress conducted by the EBA, plus 10 additional tables for banks falling under the SSM. The efforts required by institutions to complete the Excel sheets is immense, since the table fields must be manually assigned to internal systems. This turns into a real problem if the regulatory requirements keep changing. On top of this, efforts for quality assurance are estimated at roughly three times the efforts for collecting data. Clarity with respect to many requirements remains broadly absent: in some cases, it is completely unclear which values need to be entered into individual cells. Likewise, definitions of certain variables are still unclear. In such situations, bank staff may turn to EBA for clarification, within the framework of a questions and answers (Q&A) process specifically established for this purpose. The EBA will then work out detailed requirements which it will disseminate among participating banks. Looking at comparable data-collection exercises in the past, institutions often considered certain fields to be clearly defined and made the corresponding calculations on that basis. If EBA provides a response to a query submitted by another institution at a later stage, banks that already carried out calculations need to incorporate changes at very short notice. Having clearly-defined rules and definitions at the outset would have been desirable indeed. In addition to completing the tables, institutions are required to document how they have implemented the stress test (e.g. describing the simulation of scenarios). Guidelines as to how this documentation will have to be 22 The Association of German Public Banks

Structure of data queries provided were published on 27 May 2014. The purpose of this documentation is to explain the respective bank's stress test results and to provide an overview of the robustness of the methods used. Whilst no concrete structure has been set for the documentation, there are detailed minimum requirements which not only relate to the factual specifications but also specify the scope (between 10,000 and 60,000 words) and the file format. In this context, the language in which the documentation needs to be drafted is a critical issue, given that the documentation is to be submitted to both the national regulatory authority and to ECB. As a general rule, when communicating with the ECB, institutions are free to submit all documents in the official language of their home country. However, both national supervisory authorities and the ECB have been pressing institutions to submit documentation in English to a large extent. We are committed to the principle that no institution should suffer any disadvantage from the fact that it exercises its right to use the German language for such data queries. Additional data queries by regulators On top of the stress test itself, regulators have imposed several additional related data queries with further very short deadlines: 'traffic light' assessment of the implementation progress, and of the stress impact in various parts of the stress test (29 April to 12 May 2014); submission of capital planning in the event of a capital shortage (approx. 14 May to 6 June 2014); preliminary submission of the inventory data as at 31 December 2013 (14 to 26 May 2014, extended until 2 June 2014). Requests made at such short notice continually upset existing resources planning. This is why the institutions have welcomed the deadline extension for the preliminary submission of data, which the German banking sector has been able to negotiate. The Association of German Public Banks 23

Join-up with the AQR 9 Join-up with the AQR The ECB keeps emphasising that this stress test differs from those carried out in the past; namely, that the review of AQR data (which relates to the past and the present) will be jointly assessed with forward-looking stress test results. The purpose is to gain a comprehensive picture of European banking sector stability, in order to strengthen the markets' confidence in the banks. AQR and stress test results are supposed to be combined "in a mechanistic and replicable manner". This process will be carried out by a centrallymanaged team comprising experts from national regulatory authorities and the ECB. However, the exact manner in which AQR and stress test will be combined is as yet unclear. Details have still not been published. We demand a transparent process for the join-up of AQR and stress test results. Looking at the specifics relating to the various institutions, the methods used must be discussed individually with the banks concerned. 24 The Association of German Public Banks

Re-capitalisation 10 Re-capitalisation In the event of a capitalisation shortfall being discovered in the course of the Comprehensive Assessment, banks will have between six and nine months to remedy such shortfall. Any shortfall discovered within the scope of the Asset Quality Review, or in the base scenario of the stress test must be covered Common Equity Tier 1 capital instruments within a period of six months. A nine-month deadline applies to any capital shortfalls stemming from the stress scenario; certain other equity instruments are eligible for covering this type of shortfall. However, the eligibility of additional tier 1 (AT1) instruments for the purpose of covering shortfalls identified in the adverse stress test scenario is limited, and depends on the trigger point of conversion or write-down. The purpose of this restriction is to ensure a focus on high-quality capital instruments. We demand that any capitalisation measures for individual banks arising from the stress test be planned jointly with the institutions concerned and that any measures are taken with a sense of perspective. It is decisive that potential capitalisation measures as a consequence of the stress test will not trigger any state aid control proceedings. The Association of German Public Banks 25

List of Abbreviations List of Abbreviations AQR Asset Quality Review AT1 Additional tier 1 CCP Central counterparty CET1 Common Equity Tier 1 CVA Credit Valuation Adjustment EBA European Banking Authority ESRB European Systemic Risk Board EU European Union ECB European Central Bank IRBA Internal Ratings Based Approach LGD Loss given default PD Probability of default RWA Risk-weighted assets SSM Single Supervisory Mechanism 26 The Association of German Public Banks

Published by: Bundesverband Öffentlicher Banken Deutschlands, VÖB Lennéstrasse 11, 10785 Berlin, Germany P.O. Box 11 02 72, 10832 Berlin, Germany Telephone +49 30 81 92-0 Fax +49 30 81 92-2 22 E-mail: presse@voeb.de Internet: www.voeb.de Author: Nadja Wick Date of Publication: June 2014 Cover picture: ECB Tower Kristan - Fotolia.com Production: DCM Druck Center Meckenheim

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