OREANDA-NEWS. November 17, 2015. Additional disclosure about conduct risk under the European Banking Authority's (EBA) 2016 bank stress test may add further information to an area that has given rise to substantial fines for EU banks, says Fitch Ratings.

EU banks already publicly disclose their contingent liabilities and describe ongoing litigation procedures. But in many cases markets have been surprised by the heavy fines imposed for mis-selling of financial products, violation of rules and manipulation of markets.

The draft 2016 stress test methodology may force banks to think more carefully about their exposure to conduct risk. The EBA is asking banks to project losses arising from new conduct events to end-2018. By requiring banks to project and itemise conduct risk losses, this might help market participants estimate how much additional capital banks might need to cover such risks. Disclosure could be fraught with complications, however, not least the level of uncertainty surrounding these items, which may mean that the incremental disclosure over and above what is provided in banks' annual and interim financial statements may be limited.

A further additional element included in the 2016 test relates to the impact of foreign-currency lending risk on solvency, which will allow the capture of additional risks that arise when unhedged borrowers struggle with loan repayments as local currencies depreciate against the foreign-currency obligation. This may arise for example in eurozone banks that have been active in granting Swiss franc mortgages to borrowers without equivalent currency income streams.

The EBA 2016 test methodology also brings new elements to the net interest income stress. Banks will have to incorporate risks related to a sudden change in the general "risk-free" yield curves. This appears prudent in light of the impending US Fed rate decisions. In addition, basis point shocks applicable to effective interest rates are specified for the first time. The greater prescriptive detail means banks will be applying a standard set of shocks, which will increase comparability.

One surprise is that, unlike in previous years, the test sets no minimum capital threshold for participating banks. This may dilute the value of the test as there is no clear "pass" or "fail" measure. Instead, results of the stress will be communicated to local supervisors and form an integral part of the 2016 Supervisory Review and Evaluation Process (SREP). The SREP is intended to ensure banks have adequate strategies, processes and mechanisms to cover their risks, including those stemming from potential weaknesses in business models, internal governance and controls.

Fifty-three EU banks will participate in the 2016 stress tests, representing 70% of EU banking sector assets. National Bank of Greece (NBG) is omitted because it was assessed under the ECB's Comprehensive Assessment in October 2015. Comparability of NBG's assessment with the broader 2016 EBA test results will be distorted because NBG's assessment is based on end-June 2015 financials, whereas the stresses will be based on end-2015 figures. Thirty-nine banks in the stress fall under the Single Supervisory Mechanism; process harmonisation is even more important for these because the ECB needs to compare standardised data across them.