Regulatory reporting, stress testing and financial stability in Europe in the face of COVID
The European Insurance and Occupational Pensions Authority (EIOPA) has published a Financial Stability Report examining key risks in the European insurance and pension sector. It emphasises that the pandemic crisis is still not over and many uncertainties remain. Some negative impacts may be yet to reveal their full impact as fiscal measures are withdrawn, particularly increased unemployment and corporate credit downgrades. It also looks toward emerging risks around cyber security and climate change.
At the same time, the pandemic highlighted that the insurance and pension sector are better prepared due to the Solvency II regulatory framework, with regulatory reporting forming an important contributor to stability through greater transparency and appropriate decision making. The ongoing crisis also underscores, however, both the critical importance of coordinated approaches among the national competent authorities and the need to continue analysing risk and strengthening methodological approaches to capture emerging risk; to aid with the latter EIOPA has launched an external research platform, and is currently running an EU-wide insurance stress test. The report also includes a thematic article on the impact of stress tests on equity prices and systemic risk. It finds that the impacts of stress tests seem to be limited – meaning that they successfully avoid negative effects on financial markets – with some evidence that they may reduce systemic risk.
The same issues are explored in the banking sector in two publications from the Bank for International Settlements (BIS). A report on ‘Early lessons from the Covid-19 pandemic on the Basel reforms,’ suggests that the reforms have worked as hoped when faced with a crisis. High quality capital and liquidity levels required by the reforms helped banks absorb the shock of the pandemic, and the banking system would have faced greater stress without the reforms. Says Pablo Hernández de Cos, Chair of the Basel Committee and Governor of the Bank of Spain:
“Covid-19 serves as a reminder of the importance of having a resilient banking system underpinned by global and prudent standards. The Basel III standards implemented to date proved critical in ensuring banks remained resilient and supported the real economy through an unprecedented shock. This lesson should strengthen our resolve to finish the job and implement the remaining Basel III reforms.”
A working paper on the ‘Limits of stress-test based bank regulation,’ raises the issue of signal-to-noise ratio in supervisory risk assessments such as stress tests. It finds that, while disclosure of assessment outcomes can improve market discipline in general, when assessments are ‘noisier’ and less accurate they can amplify risk taking by banks. A subject for further exploration, and one which underlines to us the importance of designing reporting to collect structured data that is as accurate and consistent as possible.