EU tests banks' ability to withstand 'high-for-long' interest rates

European Union banking regulators on Tuesday launched a stress test to check how banks could cope with a long period of high inflation and interest rates just as the European Central Bank is expected to raise borrowing costs further.

The latest bi-annual stress test reflects the change in the macroeconomic environment, as Russia's invasion of Ukraine has helped to push inflation in Europe to decades-highs and interest rates have risen rapidly to tackle it.

The previous stress test in 2021 was set against a "low for long" interest rate backdrop.

The broadest and toughest test to date, it assumes that Russia will cut off its remaining gas supplies to the EU, sending energy prices surging, and EU inflation to 9.7%, compared with the euro zone peak of 10.6% last October.

Stress tests have become a regular feature for banks, initially to recapitalise them after being bailed out by taxpayers in the global financial crisis more than a decade ago, and more recently to check on-going resilience.

The European Banking Authority (EBA) said the latest test of theoretical shocks, designed in conjunction with the ECB, covers 70 EU banks, 20 more than in 2021, representing 75% of the bloc's total banking assets.

"The narrative depicts an adverse scenario related to a hypothetical severe worsening of geopolitical developments, accompanied by an increase in commodity prices and resurgence of COVID-19 contagion," EBA said in a statement.

This leads to a 6% drop in GDP, a surge in unemployment, falling property prices, cuts in gas supplies, and persistent high inflation and high interest rates over a three year period to 2025.

Bank-by-bank results, with no pass or fail mark, will be published at the end of July, to inform annual regulatory assessments of capital buffers.

A bigger sample of banks makes it possible to introduce a more simplified approach to assessing risks, EBA said.

There is also new, more detailed approach to how the shocks feed through into sectors banks are exposed to, though links to non-banks, such as investment funds, now a regulatory focus, or climate change are not explicitly included.

EU regulators want more scrutiny of fallout on the banking sector after the supply chain disruptions following the pandemic, and the higher vulnerability of energy-intensive sectors following the Ukraine war.

The test contrasts with the ECB's actual outlook of inflation falling to 6.3% this year and 3.4% next year. The ECB also sees economic growth accelerating from this year's 0.5% to 1.9% next year.