 through the future of financial services, and very lively journey as well. We continue on the theme of the future by looking at the future of stress testing. And for that, please join me, ladies and gentlemen, in welcoming Andrea Nria, Chair of the ECB Supervisory Board, who will deliver his keynote speech on this topic. So good afternoon. Well, stress test is a topic I've been dealing with for a while, so it's a pleasure, and I thank very much Francesco and Tuomas for having invited me to address this tonight. I will start a bit back from 1628, when the Vasa, the prize of the Swedish Navy, was the most powerful warship in the Baltics, until she sank about half an hour into her maiden voyage, that is. So what happened? Well, nothing special when it comes to sailing ships. The winds simply picked up. The problem was that the Vasa's design was rather unstable. She had been built for the shallow waters around Stockholm, so not too much of the ship was below the water line, and a lot of weight was concentrated in her hopper structures. Thus, when the wind picked up, it pushed the ship so far over on its port side that water poured in through open gun ports. And that was the end of the Vasa and the huge embarrassment for the King of Sweden, Gustavus Adolphus. Now, why am I telling you the story of the Vasa? Probably you guessed that. In my view, it shows how beneficial it is to spend a moment or two thinking about what might happen if the wind picks up. This is true when it comes to building ships, and in a sense, it is also true when it comes to managing banks. How will landers fare in difficult times? Are they stable enough to weather a storm, or do they need additional weight below the water line in the form of more capital? These ideas sound straightforward, but it is only recently that stress tests for banks have entered the picture. It was the IMF and the FSAP in the Financial Sector Assessment Programs that started it, and it took more than 20 years before it became a regular tool to be used by supervisors, starting with the 2009 SCAP exercise in the US, and then with the European exercises after that. So let's take a closer look at the evolution of stress testing and its objectives, and how it might need to be adapted in the future. General goal of a stress test is quite simple to assess how the ship would weather a storm and what shape it would be in afterwards. In terms of banks, how would the bank fare if the economy took a turn for the wars? Would it survive, and would it still be able to provide loans to help the economy recover? Answering these questions has been the core intent of the stress test since they were first introduced in Europe, but over time, they've also served other topical purposes. Stress tests were used during the last financial crisis to gauge the size of the capital holes in bank balance sheets, and there were key elements in determining how much additional capital needed to be provided. These helped to reduce uncertainty and calm the markets, not least because some banks took upcoming stress tests as a cue to preemptively build up capital. At the time, there was a difficult challenge of addressing the risk triggered by the sovereign debt crisis in Europe, and so the choice was made to provide extensive disclosure to the markets with a view to helping them correctly assess the risks of individual banks, also when we as supervisors were not in a position to put a capital tag to sovereign exposures. And this in turn helped to bring about much more effective market discipline. Then in 2014, stress test featured heavily in the comprehensive assessment that preceded the establishment of the European Banking Supervision. And here, they helped level the playing field for banks from 19 countries with different accounting practices and supervisory practices. It was this stress test, for instance, that first relied on the benefits of the single rule book, which provided a fully harmonized definition of capital and non-performing loans for the first time in the capital regulations, capital requirements regulation, and the standards of the European Banking Authority. Since then, stress tests have become a regular transparency and benchmarking exercise, but their focus has shifted. Rather than measuring the actual size of capital holes against a supervisory yardstick, stress test now help us spot vulnerabilities in banks. Also, the dialogue between supervisors at banks has become more important as the stress test is seen as a tool to strengthen banks' own risk management. Ever since they were first used, stress test have helped to make the banking sector more transparent. As I mentioned in Europe, disclosure rules has always been a key feature of the exercise. Over the years, stress tests have remained an important tool for supervisors, and what we learn from them guides us to shape our SAP, not the supervisor review and evaluation process, and the stress test results are used, for instance, as a starting point when setting the so-called P2G, the pillar-to-guidance, the buffers above the minimum requirements. Likewise, the insight we gain from stress tests can also inform supervisory follow-up in on-site missions or internal models investigations. No matter which goals they have served, stress tests have so far proved very useful, but we have to acknowledge one thing. The attempt to align different, sometimes conflicting objectives has led to a fairly complex and resource-intensive exercise, and this, in turn, has led to a certain amount of discontent among supervisors and banks alike. So 10 years after the crisis and five years into European banking supervision, it is time to rethink the design of stress tests. When discussing the future of stress tests in Europe, we can rely on three yardsticks to gauge how best to proceed. Realism, relevance, and resources, so three yards. We need a stress test that paint a realistic picture of individual banks. We need stress tests that is relevant for supervisors, banks, and markets alike, and we need a stress test that balances costs and benefits. All these things are connected, of course, but let's start disentangling them and addressing them one by one, starting with realism. First, let's look at the methods we used to calculate the impact of stress scenarios. Currently, we rely on a constrained bottom-up approach. Banks use their internal models to calculate how their capital position would change in a stress scenario. However, we impose some constraints on these models. Static balance sheets are one of them, and we assume that management would not attempt to mitigate the impact of the stress. Such constraints act as safeguards that discourage banks from engaging in a beauty contest where they strive to look good instead of real. They make the results of the stress test easier to compare and more conservative, and they also make quality assurance less complex. All these comes at cost of realism, though. But what exactly does realism mean for an exercise that is based on hypothetical scenarios? To me, it means that the results of the stress test accurately reflect how the hypothetical stress would actually affect the bank's balance sheets. In other words, if it rains in the economy, how the water would trickle down or pour into the balance sheets. So if you want to make the stress test more realistic, the constraints might be one of the levers to pull. We might ask, for instance, whether it is realistic to assume a static balance sheet or the constraints that we have on income generation in stress scenarios and so on. And banks do ask, believe me, selectively relaxing the constraints would allow us to better account for bank-specific factors and management actions, and these would make the results more realistic. Also, the constraints might seem, might be seen as being the main driver of the results rather than a backstop to ensure their credibility. In this case, and it has happened several times in recent exercises, banks tend to consider the exercise irrelevant from an internal risk management perspective. And this view often makes banks very reluctant to publish final results which do not reflect their own views on risks. On the other hand, the realism of the exercise is also challenged because it easily turns, as I mentioned, into a beauty contest. Banks direct their efforts to model the stress away in order to look good to supervisors and investors. And the experience from the first rounds of the European stress test showed that banks indeed often try to compensate losses in the adverse scenario. For instance, by adopting overly optimistic assumption when estimating their income in the adverse scenario or being very positive on what management can do in counterbalancing the stress in turbulent market conditions. We also see banks conspiring to game stress test often with the help of external advisors. Data collected from banks ahead of their submission to supervisors by an external advisor. And each bank is informed of its position vis-a-vis its peers, which of course has an impact on the, let's say, on the adjustment of the submissions and may eventually minimize the effect of the stress scenario. We see this, we don't like it, and we won't tolerate it. So we will take measures to avoid this happening again in the future. Naturally, realism is closely linked to the second of my points in the list, relevance. The more realistic the results are, the more relevant they should be. But the notion of relevance may differ according to the objective that the stress test aims to achieve. For banks, the stress test might be most useful for risk management purposes when the methodology and the scenario are tailored to the specific business model and risk profile of each bank. That's ideally, there should be a tailor-made stress test for each and every bank. Supervisors to care about the ability of the stress test to capture the risk profile of each bank, but they also need the results as input in setting capital buffers, the pillar to guidance. As this is an administrative decision, an administrative measure, consistency across banks is crucial. Each bank should be subject to a significant and commensurate stress which challenges its resilience in a similar way and provides comparable input into the supervised review and evaluation process. Macroprudential authorities want to assess how resilient the system as a whole is. They want to see out a single shock that these banks at a certain point in time would spread throughout the system and now interconnections would pan out and eventually hamper the ability of the system as a whole to serve the economy. Finally, there are the markets. For them, relevance is closely linked to transparency. In other words, does the stress test provide valuable additional information on individual banks? I believe the European stress test is one of the most transparency in the world. We publish a huge amount of data bank by bank and based on common definitions. But there is one thing that markets cannot see, the link between the stress test results and the supervisory action. While we are very transparent on the results, we remain quite opaque on how they translate into capital add-ons. I'm very much aware that both banks and supervisors have concerns when it comes to ensuring enhancing transparency in this area. They are worried, for instance, that if you increase transparency on the buffers, they would be seen actually as minimal requirements and the markets would not allow them to be used while the actual purpose of the capital buffers is that they would be used if the stress were to materialize. But to be honest, I still think that we need to seriously consider this closing pillar to guidance at some point. And this is particularly true in a bailing world where private investors and not taxpayers are supposed to be first in line when it comes to picking up the bill following a crisis. Let me now turn to the final item on my list, which is resources. A stress, I will be quick here, but it would require probably longer to be fair. A stress test is a complex exercise and as I've said before, it is extremely resource intensive for both banks and supervisors. This might be justified as long as the test produced realistic and relevant results, but still we need to strike a balance between costs and benefits. And currently, the impression seems to be that the amount of resources deployed is quite high when set against the value of the information that is generated. I believe that all the stakeholders would agree on the basic idea that if you want to take stress testing from infancy to maturity, we need to progress in all three dimensions. We need to make it more realistic, more relevant and less resource intensive. Yet views differ significantly as to the best way forward, even among supervisors I can tell you. So how can we square the circle? Let me first and foremost say that when discussing the future of stress testing in Europe, we must keep in mind that the future means post-2020. So the upcoming stress test will certainly follow the current approach. Nevertheless, the time for debate has come. We need to open up and open a genuine discussion on these topics. So far I've discussed the three yardstick that stake out the bounds of possible futures so realism, relevance and resources. And while I've taken them one by one, in reality they are all linked. And unfortunately these links sometimes take the form of trade-offs. Thus there are many parts which we can arrange in different ways depending on how we want to balance them. Imagine we decided to relax constraints in the bottom-up approach. Banks would be free to depart from a common methodology or scenario to better reflect their individual business model and risk profiles. The results of the stress test would become more realistic and more relevant to banks, which is good. However, supervisors would have a hard time using the results of such an exercise to determine capital buffers in a consistent way across banks. They would need to invest more time and energy in quality assurance which would require additional resources. So an alternative which is sometimes voiced is that supervisors should focus more on top-down stress tests as it is done in the United States for instance. Thus they would run the exercise with their own models and fully control the consistency of the results. But then much less information would be provided to the markets. After all, banks would not accept the publication, rightly so I think, of very granular risk parameters which would not reflect their own views on risks. I think the root of the problem lies in the fact that we are trying to do too much with too little. To, let's say, get light in many rooms with a single candle. If we aim to achieve several goals, some of which conflict with each other and we aim to serve different customers, the stress test is bound to disappoint all of them. So I wonder whether the time is right to consider some bolder solutions. My point would be why not split the micro-prudential stress test into a bank view and the supervisory view. The bank view would stem from a largely unconstrained bottom-up approach. There would be no quality assurance, but banks would have to explain where and why they deviate from the constraints defined in the common methodology. This would allow each bank to account for its individual circumstances and each bank would have an added incentive to invest in risk management. The stress test would become much more realistic and more relevant as a result. It could provide useful granular information to the markets. At this point, some might argue that banks would get overexcited about the freedom they would gain and this could lead to a lack of conservatism. This is where the supervisory view comes in and it would rely still on a constrained bottom-up approach and top-down models would be used to provide quality assurance for the results and focus benchmarking. So it would be to some extent similar to the approach that we have followed in 2018 and will follow in 2020. However, some methodological constraints including the static balance sheet assumption could be relaxed somewhat to increase realism. Likewise, the exercise could be streamlined and thus become less resource-intensive. First, there would be less quality assurance cycles, which I can tell you are quite resource-intensive as there would be no need to align the bank view to the supervisory view. Second, the outcome of the supervisory view would only be published in terms of capital depletion and would be made less granular and there wouldn't be this conflict on the publication of data that banks do not recognize. And third, some design features of the bank view and the supervisory view could be aligned which would allow avoid duplicating efforts and these two would save resources. At the first top-down stress test would continue to support quality assurance, but in the longer run, as accuracy and reliability improve here in Europe, we might consider relying even more on top-down stress test for the supervisory view. At the bank view and the supervisory view would then be published next to each other so that markets could form their own view on them. To sum up, splitting test tests into two components could help make them more realistic and relevant without taking up more resources. Let me conclude. I mean, stress tests have become an important tool for supervisors in the wake of the financial crisis and in Europe we have benefited greatly from their use. And I'm indeed a great believer in stress testing, but you do also see the need to refine the exercise and adapt it to the post-crisis world. I've outlined few ideas to you today but they are only ideas at this stage and we need a debate. And, but if we agree that we need to move towards something more realistic, more relevant, but less burdensome, then it is these ideas that probably we should focus on. This brings me back to the Vasa. The twist in the story is that the captain did design a rudimentary stress test and to gauge the stability of the ship, he had 30 of his men run from one side of the deck to the other in order to make a roll. A roll she did. However, a representative of the king was on board and he stopped the test. And his main concern was that the stress test itself might sink the ship. So my final message is that we should be open minded in the conversation about the future of stress tests, but the bottom line is this. They should remain serious, challenging and credible exercises and help supervisors to ensure the safety and soundness of banks. So thank you very much for your attention. Thank you very much, Andrea. Thanks for rounding up these discussions today on the future while hinting also at the past, including the past of the Swedish Navy. This runs up our discussions today. Tomorrow we will resume at 9 a.m. sharp. So please be on time. However, before that I have really the pleasure of inviting you to a reception that will be held downstairs on the ground floor. Colleagues will guide you there from the elevators. And with that I wish all of you a nice evening. Thank you and see you tomorrow.