Banks got used to an implicit and costless government guarantee, which kicked in when things went wrong. Sound and prudent management was often considered less important. Banks could boost their profitability by investing in riskier assets. That way, they could reap higher returns, knowing that the risks would be borne by others, by taxpayers. 2/9  BIS central bankers' speeches  And neither shareholders nor investors provided the necessary checks and balances. They lacked incentives to monitor banks’ risks. They often expected outsized returns, knowing that the banks would need to take equally outsized risks to earn these returns. But they didn’t care too much; investors too lived in a world where profits were gained by the few but losses were imposed on the many. Funding costs of systemic banks were too low, which allowed them to grow even larger, making them “too big to fail”. At the end of the day, banks and their investors had little incentive to act in a sustainable and forward-looking manner. So banks must be able to fail for all the reasons I just mentioned. Making banks fail again When’s the right time? Against this backdrop, the aim of all the regulatory reforms was not just to make banks more resilient. They also aimed to make banks fail again. But don’t get me wrong here. Failure is the least desirable option, of course. Above all, we need healthy and well-functioning banks. But still, sometimes banks do fail.
Do the banks have enough capital to absorb any losses in either scenario? And the crucial question that follows is, of course: what if they don’t? Well, let’s take a brief look at the upcoming stress test. This year, the European Banking Authority, EBA for short, will conduct a stress test involving the largest banks in the EU. This test includes 37 banks from the euro area which are directly supervised by the ECB. To obtain a fuller picture, we will, in parallel, stress-test most of the remaining large banks in the euro area, using the same scenarios and methods as the EBA. In respect of capital shortfalls, the stress test is not a pass-or-fail exercise. The banks do not have to meet certain thresholds. Instead, we supervisors will decide on a case-by-case basis whether banks have a capital shortfall, taking into account their individual risk profiles and their individual capital needs. 7/9  BIS central bankers' speeches  At the end of the day, stress tests may deal with hypothetical scenarios, but their results can have very real consequences for the banks. They inform the work of supervisors, and they inform market expectations when the results are published, as they will be in the case of the EBA’s stress test. They are also a moment of truth for the banks. More generally, stress tests help supervisors and banks to spot and remove weak points in banks’ resilience early on. If this is not done, problems can quickly mount up.