The upcoming stress tests facing the large U.S. and European banks are likely to be the toughest to date, which may push the big banks to bolster their capital buffers, says Fitch Ratings in a new report.
The rating agency noted that the 2023 stress tests by regulators in both the U.S. and Europe will model the effects of a “significantly” bigger drop in GDP growth than recent stress tests have used.
For instance, the severe adverse scenario in the U.S. stress tests assumes a deep global recession and prolonged drops in both residential and commercial real estate prices, which weigh on corporate profits and investment sentiment.
While the stress tests in 2021 and 2022 modelled 4.0% and 3.5% GDP declines respectively, this year’s test will examine an 8.75% drop in real GDP, Fitch said.
At the same time, the European Union’s test will use a 6% drop in GDP, rising unemployment and stubbornly high inflation — amid growing geopolitical tensions, rising commodity prices and a resurgence in Covid-19 contagion, it noted.
These tougher scenarios could drive higher credit losses and more severe capital declines in this year’s stress tests, which could lead to higher capital buffer demands, Fitch said — as regulators set buffers that are linked to the banks’ “capital depletion under the adverse scenario.”
Additionally, the report noted that Chinese regulators recently published their draft final Basel III rules, which are largely in line with global standards, and are expected to take effect in January 2024.
When they do take effect, “the new rules will have a limited impact on banks’ capital ratios,” the report said.
“However, more stringent asset risk classification requirements, which go live this July, will reduce management discretion and may negatively impact capital ratios by increasing expected credit losses,” it noted.