Ring fencing and consolidated banks’ stress tests

• Stress tests often omit potential risks embedded in banks’ geographical structures.
• We present a framework where capital/liquidity is not fully transferable within the group.
• Using EBA data, we estimate the impact of ring fencing on capital and/or profits.
• Outside the EU ring fencing could trigger up to 3% points of new Core Tier I capital needs.

The recent crisis has spurred the use of bank stress tests as a crisis management and early warning tool. However, a weakness is that current stress tests are based on consolidated balance sheets, and thus omit potential risks embedded in banking groups’ geographical structures by assuming that capital and liquidity are available wherever they are needed within the group. This study presents a framework to integrate ring fencing and regulatory differences (e.g., minimum capital requirements) into cross-border bank stress tests. Case studies show how some forms of ring fencing—home or host regulators limiting flows of capital and income within a group—could significantly increase banks’ capital needs.