Stress testing and scenario analysis : another way of determining regulatory capital for European commercial banks

Abstract

Purpose - The purpose of this study is to capture the relationship between credit risk of European commercial banks and their profitability, taking into consideration regulatory requirements under several stressed scenarios. Design/Methodology/Approach - The sample of this study consists of 12 out of 15 largest commercial banks in Europe as measured by their total assets in 2017. This study uses hypothesis testing and stress testing approaches to capture the relationship between credit risk of banks and their profitability and to determine the sufficiency of bank capital adequacy. Findings - The results showed a negative correlation between capital adequacy ratio and the return on equity, and a positive one between the non-performing loans ratio and the return on equity. Furthermore, the relationship between loans to customer deposits ratio and the regulatory total capital ratio is positive. After running stress tests, we observed that banks' operating profit has a positive impact on Tier 1 regulatory capital ratio and banks' risk exposure. Research Limitations/Applications - The limitation of this study is the lack of transparency in the financial market and availability of balance sheet data for banks. Additionally, the complexity of stress tests required advanced software usage instead of straight forward calculations. Practical Implications - A good implementation of stress tests and scenario analysis might make it easier for banks to have a better allocation of capital, to mitigate risks that arise from lending, and to predict losses that might arise from certain financial events. Originality/Value - This research tackles more advanced techniques such as stress testing and scenario analysis for the determination of regulatory capital for banks, rather than the usually used ones by previous researches.