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Opinion

Benchmarking the European Central Bank's Asset Quality Review and Stress Test: A Tale of Two Leverage Ratios

By Viral Acharya and Sascha Steffen

Viral Acharya on flight from US treasuries

A crucial weakness of the previous stress tests in Europe has not been addressed this time around, in particular, the use of a single regulatory benchmark for capital adequacy that is based on static risk weights to assess the financial sability of the European banking system.

In November 2014, the ECB published its asset quality review (AQR) and comprehensive assessment (ECB 2014), as well as capital shortfall estimates based on its stress test. These results differed widely from our earlier assessment (Acharya and Steffen 2014). Indeed, the two shortfall estimates are negatively correlated.

Calculations that we have recently completed suggest that the divergence between our numbers and those of the ECB can be explained by the continued reliance on static risk-weights in the regulatory assessment. In fact, using the projected losses in the adverse scenario employed by the ECB and applying a different (non risk-weights based, i.e. simple) leverage ratio gives results much closer to ours.
Shortfall measures

We compare two measures of capital shortfall, the “regulatory shortfall measure” as used by the ECB, and SRISK as calculated by NYU Stern School of Business Volatility Lab. Both concepts are conceptually similar as they estimate losses in a stress scenario and determine the capital shortfall between a prudential capital requirement and the remaining equity after losses.

Read full article as published by VoxEU

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Viral Acharya is the C.V. Starr Professor of Economics and the Director of the NSE-NYU Stern Initiative on the Study of Indian Capital Markets.