How stressed are the stress tests conducted on European banks?

Understanding of the stress test prerequisites a basic understanding of the Basel norms and the Capital Adequacy ratio. To put it in simple english, the Basel norms states that, the banks can’t build assets (lending) purely based on the borrowing (deposits). Rather, a portion of the lending is supposed to be backed by one’s own capital which will be proportionate to the risk of the assets

For example, if a bank has an exposure of 100 Cr. in a personal loan portfolio, and the value at risk for this portfolio is 20%, the amount of capital to be maintained to have an exposure of 100 Cr. in this loan portfolio is 20% * 9% * 100 Cr (9% is the Capital adequacy ratio advised by the RBI to the Indian banks) = 1.8 crore.

Having understood how the CAR is calculated, let us move to the next step of how this figure 20% is arrived at. Traditionally (Basel I norms), the central bank dictates this risk weight-age for various asset classes based on its analysis of the economy. (This has also been used by the central banks to restrict or enhance the flow of money to any particular sector).Basel II norms gives freedom to the bank to arrive at its own figure based on the borrowing characteristics of its customers and stop with just suggesting the mathematical model to compute this figure.

There are primarily two ways of calculating this figure. One is VaR method which calculates the value at risk for any portfolio in 99% of the case. This is done by mathematical simulation based on historical data. Another method involves, calculating key parameters like Probability of default (% of customers who will default in a portfolio), Loss given default (in case a customer default what will be the loss for the bank) and Exposure at default (The extent to which the customer would have utilized his/her credit line by the time he/she defaults). The product of these three parameters along with adjustments gives the risk of that portfolio. The Basel Committee advises to take historical data of at least 7-8 years to cover the variations in the business cycles.

The problem here is that, as you might have noticed, the banks hold capital only to the extent of value at risk 99% of the time or the average loss that may arise in a portfolio. Whereas today’s situation as evident is beyond this 99% range and certainly not normal. 

Also, the stress test is supposed to assume the worst case of defaults for all the portfolios and see whether the capital of the bank still holds good. Whether they have taken all the worst scenarios enough to make this test stressed? The most feared, the event of default of sovereign bonds is not at all taken! Though they assure that such an event will never occur, why should they be excluded? Shouldn’t the stress tests capture the worst case scenarios? 

Certainly, going by the basel formulas, most of the capital of the most of the banks should have been compromised by the ongoing economic crisis. This being the case, saying that just a few billion is enough to regain the cut off of 6% (set for this stress test) doesn’t sound convincing. Also while adjusting for the loses arising out of holding government securities, only trading books were considered and not the portfolio of bonds under “Held till maturity” (Bonds held under trading book constitutes just a fraction, usually in one or two tenths of the bonds held under HTM-Held till maturity). Is it appropriate to call this as “stress test”?