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Stress tests 'showing their age' and need revamp: Scope Ratings

Stress tests are "showing their age" and need a revamp in a world where capital adequacy and asset quality are no longer the biggest challenges to stability, according to Scope Ratings.

With the rise of emerging threats such as cybercrime, misconduct by bank employees and the disruptive impact of digitization, "stress tests are essentially fighting today's battles with yesterday's tools," Sam Theodore, managing director at Scope Ratings' financial institutions group, said in an interview.

It came as no surprise that all of the banks tested in both the European Banking Authority and Bank of England's recent stress tests graduated successfully, according to Scope Ratings' outlook for 2019.

Apart from a handful of outliers, most major European banks are sufficiently capitalized, according to the Dec. 11 note.

While stress tests were "highly relevant in the asset quality-challenged post-crisis years," they are starting to have less relevance as a means of assessing a bank's stability, according to Scope.

Emerging threats such as cyberrisks are "hardly stress-testable, at least not based on existing methodologies and models," the note said.

"Capital doesn't protect you against a huge cyberattack or money laundering. There is a tendency for people to say 'the bank is well capitalized' and that is the end of the story. But there is a need for fresh thinking," Theodore said.

It is extremely difficult to measure a bank's sensitivity to a black swan event such as a cyberattack, or to criminal activity such as fraud or money laundering carried out by an employee, he said.

'Subdued' profitability

Scope analysts also pointed out that profitability at European banks is likely to be "subdued" in the coming year, as interest rates look set to remain stubbornly low, pushing down investment yields and net interest margins. Tougher prudential regulations, which mean that banks need to hold more capital in reserve and put constraints on certain lines of business, will also have a dampening effect on profits.

It may be time for investors to change their expectations of what a respectable return on investment for a bank is, according to the report.

"A high-single-digit ROE is not a weakness for a bank, especially not when its risk profile is sound, and its business model is viable and sustainable. We take comfort from the fact that this message has gradually become more palatable to investors — even to equity investors, as bank equity valuations in recent years have been far from reflecting a general funk."

Scope Ratings argued that there is a widespread, and probably incorrect, belief that European banks could become more profitable they could only reduce costs further, boost lending volumes and flush out more toxic debt.

"This belief is too often reinforced by senior regulators and policy makers, with the difficult-to-implement message that banks should boost profitability to get stronger, but without taking additional risks," the report said.

Scope does not expect the European banking sector become significantly more profitable.

"There is nothing intrinsically wrong with lower profitability as long as the bank isn't taking unnecessary risks," Theodore said.