MICRO STRESS TESTING

Charles Augustine Abuka

MICRO STRESS TESTING FOR COMESA COUNTRIES

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INTRODUCTION

• The stress testing framework laid out in this Manual is designed as an element that should complement existing analytical tools within the COMESA member countries.

• The exercise is aimed at assessing the resilience of commercial banks to adverse developments and contributes to the overall assessment of systemic risk.

• It initiates the process of moving from single factor sensitivity analysis towards macro-scenario analyses.

• Users should recognise that this move requires a greater understanding of the inter-linkages in the financial system and spill-over effects between the markets, institutions and sub-sectors of the financial system.

• Stress tests are applied to bank level data as at the end of each reporting period.

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The role of stress-testing in financial stability analysis

• The primary purpose of stress tests is to provide insights about resilience of the whole financial sector or individual institutions to various shocks.

• Stress testing is one of the quantitative tools which help the central banks and supervisors to identify the weakest banks and/or other financial institutions.

• Stress tests are important in checking the resilience of the financial sector to various macro shocks, for example interest rate, exchange rate, GDP, unemployment and changes in terms of trade.

• In conducting stress-tests, the banking supervision department should focus on microprudential aspects, while the financial stability units evaluate the macroprudential aspects.

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The role of stress-testing in financial stability analysis.

• Used as a tool for early warning about potential future problems. • Conduct liquidity stress-tests on a monthly basis, while sensitivity

based credit risk stress-tests could be done on a quarterly cycle, and macro stress tests on an annual or semi-annual basis.

• The lack of adequate underlying micro and macro data, absolute results of the stress testing exercise should be interpreted cautiously and more weight should be given to the changes and the direction of developments in banks’ risk profiles.

• Efforts should be focused on analyzing more risky banks.• There are substantial differences among banks in terms of credit,

liquidity, market risks.

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The role of stress-testing in financial stability analysis

• In the medium term, once the COMESA central banks develop their capacities in stress testing, it would be useful to issue stress-testing guidelines for banks.

• Guidelines could comprise not only inclusion of risks, adequacy of probability of default (PoD) calculations but also common macro stress-testing scenarios.

• The COMESA countries could also use the experience of other central banks within the region to help in the preparation of guidelines on stress testing.

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Stress testing models at the COMESA central banks

• The conduct of stress testing exercises at the COMESA member state central banks was implemented relatively recently.

• Central banks in cooperation with supervisory authorities use stress tests for both micro and macroprudential purposes.

• For microprudential goals, stress tests are tools to assess forward looking risks in hypothetical circumstances and should be used in conjunction with other tools including on-going supervisory assessments.

• Macroprudential stress testing is used to assess weaknesses in the financial system as a whole, to understand the development of endogenous risks and to model second round affects in order to make relevant macro prudential policy.

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Stress testing models at the COMESA central banks

• For microprudential stress tests bank specific data is necessary. • Macroprudential stress tests require less granular information. • Probabilities of default and loss given defaults can be obtained by

linking various macroeconomic variables with NPLs, loan losses or provisions.

• Satellite models must be constructed.• Among the most important gaps are the following:

real estate market data in all the countries; some macro data, like GDP, is annual only; data on corporate and household financial accounts does not

exist; in some cases data series are too short and do not cover even a

full business cycle.

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Stress testing exercise in the COMESA region: purpose, need and perspectives

• To organize a stress testing exercise in COMESA member countries, a number of questions have to be answered: – Who is responsible for stress tests? – How scenarios are designed and chosen? – How are the assumptions or variables to be stressed examined and

chosen? – What data is available? – How frequently should stress tests be performed? – What aggregation or granularity level is selected? – How are the results presented? – What actions supervisory agency or central bank takes? – Are results published or not?

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Stress testing exercise in the COMESA region: purpose, need and perspectives

• Country level working groups on stress-testing, consisting of representatives of all departments and regulatory institutions, may be established with the following primary tasks: – development of methodology, – scenarios and aggregation of results.

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Stress testing exercise in the COMESA region: purpose, need and perspectives

• Each central bank needs to: have its own stress testing model for both, micro and macro stress testing; familiarize itself with the models and risk management practice of

commercial banks; run stress testing exercise at home; and have precise and monitor constantly data about banks’ cross-border

exposures.

• In the short term, each central bank needs to start conducting stress testing exercises on a regular basis and include them in a general macroprudential framework.

• In the long term, develop a macro-financial stress testing model and consider using the macro forecasting model projections as inputs into it.

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SUGGESTED INITIAL METHODOLOGY

• The stress testing process employs the breaking point method.

• Ong et al (2010) advises that the implementation of the breaking point method requires close coordination with on-site supervision and should be complemented by other supervisory tools and qualitative information.

• The proposed approach on the breaking point method applies uniform shocks to individual bank data and aggregates the results in order to determine the resilience of the banking sector as a whole.

• In the proposed stress tests, the risks that are assessed include credit risk, interest rate risk, foreign exchange risk and liquidity risk.

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Data Requirements for Conducting Micro Stress Tests

• Balance sheet and income statement data for the banking system as at the end of each reporting period, consisting of all commercial banks, are used.

• Stress tests are performed on individual banks in order to obtain an aggregated position of the banking system post-shock.

• Estimated losses and capital needs are calculated using a dedicated MS excel-based stress testing model.

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Variables that are considered for stress testing

• Use variables that can be interpreted as measures of financial soundness.

• Use variables that can be credibly linked to the risk factors.• The commonly used variables are outlined below:

Bank capital, Capitalisation, Profits , Profitability, Net interest income and other components of profits.

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SHOCKS APPLIED IN THE STRESS TESTING FRAMEWORK

• The shocks within the stress testing exercise cover:– credit risk, – foreign exchange risk, – interest rate risk and – liquidity risk.

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SHOCKS APPLIED IN THE STRESS TESTING FRAMEWORK

• Credit shocks

This is the point at which the first large bank fails to meet the minimum capital requirements, that is, the minimum capital adequacy ratio (CAR) and/or minimum paid-up capital as prescribed by the supervisory authorities.

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SHOCKS APPLIED IN THE STRESS TESTING FRAMEWORK

• Uniform decline in existing performing loans• Proportional increase in sectoral non-performing loans• Foreign exchange shock• Shock to banks’ net earnings• Liquidity shock

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THE WAY FORWARD

• Forecasting banks’ financial statements• Constructing macro scenarios

– a baseline scenario– adverse scenarios

• Determining macro financial linkages

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References

Haldane, A., Hall, S. and S. Pezzini, 2007, “A New Approach to Assessing Risks to Financial Stability”, Bank of England Financial Stability Paper No. 2 (London: Bank of England).Moretti, Stolz and Swinburne (2008) ‘Stress Testing at the IMF’, IMF Working Paper

  Oosterloo S. et al. Financial stability reviews: A first empirical analysis. Journal of Financial Stability. Volume 2, Issue 4, March 2007, Pages 337-355.Ong. L, Maino. R, Duma. N, (2010) ‘Into the Great Unknown: Stress Testing with Weak Data’ IMF Working Paper WP/10

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