The IMF’s Experience with Macro Stress- · PDF fileThe IMF’s Experience with Macro Stress-Testing ... • A key quantitative tool in financial stability ... Matrix of...

The IMF’s Experience with Macro Stress-Testing

ECB High Level Conference onSimulating Financial Instability

Frankfurt

July 12–13, 2007

Mark SwinburneAssistant Director

Monetary and Capital Markets DepartmentInternational Monetary Fund

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OutlineOutline

•• Overview of the FSAPOverview of the FSAP

•• Stress Testing in FSAPsStress Testing in FSAPs-- generalgeneral-- specific experiencespecific experience

•• Issues Going ForwardIssues Going Forward

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Overview of the FSAPOverview of the FSAP

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To strengthen and deepen financial systems and enhance their resilience

• Reducing the potential for systemic crises

• Limiting the severity of crises

• Addressing structural weaknesses

FSAP ObjectivesFSAP Objectives

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Analytical Tools and MethodologyAnalytical Tools and Methodology

•Financial Soundness Indicators

•Macro and sectoral balance sheet analysis

• Stress Tests•Early Warning Systems• Market-based indicators

and analysis (incl. CCA)

• Institutional, structural and market features

• The policy framework-crisis prevention and management

• Formal Standards and Codes assessments

Risks and vulnerabilities are identified using both quantitative tools and qualitative assessments

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Analytical Tools and Methodology (2)Analytical Tools and Methodology (2)

““. . . No single model is ever likely to . . . No single model is ever likely to capture fully the diverse channels through capture fully the diverse channels through which shocks may affect the financial which shocks may affect the financial system. Stress testing will, therefore system. Stress testing will, therefore remain a complement to, rather than a remain a complement to, rather than a substitute for [broader analysis] . . . .substitute for [broader analysis] . . . .””

Bunn et al. (2005)Bunn et al. (2005)

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Stress Testing in FSAPs:Stress Testing in FSAPs:

GeneralGeneral

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Stress Testing in FSAPsStress Testing in FSAPs•• A key quantitative tool in financial stability A key quantitative tool in financial stability

assessments. assessments.

•• Complemented by qualitative assessments and Complemented by qualitative assessments and other quantitative analyses other quantitative analyses

•• Tailored to countryTailored to country--specific circumstances.specific circumstances.

•• Identification of Identification of ““good practicesgood practices”” ongoing.ongoing.

•• Learning experience/tool for dialogue. Learning experience/tool for dialogue.

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Stress Testing ApproachesStress Testing Approaches• Sensitivity tests

Shocks to single risk factors

• Scenario-based testsMultiple risk factorsMultiple risk factors

•• Bottom upBottom upBased on individual bank portfolios Based on individual bank portfolios

•• Top downTop downAggregate systemAggregate system--wide modelwide model

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Stress Testing Approaches (2)Stress Testing Approaches (2)

Key features in FSAP testing:Key features in FSAP testing:

•• Internally consistent macro scenarios now central Internally consistent macro scenarios now central •• Uniformity of the shocks within each peer groupUniformity of the shocks within each peer group•• Some form of bottomSome form of bottom--up analysis is criticalup analysis is critical•• Purely topPurely top--down analysis as a consistency checkdown analysis as a consistency check• “Extreme but plausible” guiding principle•• Some flexibility neededSome flexibility needed——data and modelsdata and models

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Stress Testing in FSAPs:Stress Testing in FSAPs:

Specific ExperienceSpecific Experience

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FSAP Experience with FSAP Experience with Stress TestingStress Testing

•• Most FSAPs conduct singleMost FSAPs conduct single--factor sensitivity analysisfactor sensitivity analysis•• Recent FSAPs:Recent FSAPs:

Macroeconomic scenario analysisMacroeconomic scenario analysisInvolve the authoritiesInvolve the authoritiesInvolve financial institutionsInvolve financial institutions-- bankbank--byby--bank implementationbank implementation

Include interbank contagionInclude interbank contagionInclude nonbank financial institutionsInclude nonbank financial institutions

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Coverage in FSAPsCoverage in FSAPs

(percent of all FSAPs initiated in the period)(percent of all FSAPs initiated in the period)

37372525•• Insurance sector stressInsurance sector stress--testedtested38381111

•• Interbank contagion taken into Interbank contagion taken into accountaccount

95956464•• Scenario analysis Scenario analysis

20032003––050520002000––20022002

Stress tests have become more sophisticated over time:

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Risks Addressed in FSAP Risks Addressed in FSAP Stress Tests Stress Tests

•• Credit RiskCredit Risk

•• Market Risk Market Risk

-- Interest rateInterest rate

-- Exchange RateExchange Rate

•• Liquidity RiskLiquidity Risk

•• Contagion/Operational Risk Contagion/Operational Risk

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Credit Risk Credit Risk

•• The most significant source of riskThe most significant source of risk

•• The most in need of strengtheningThe most in need of strengthening

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Credit Risk (Credit Risk (Continued)Continued)

•• Single equation models for household and Single equation models for household and corporate sectors corporate sectors

•• Credit quality as function of macroeconomic Credit quality as function of macroeconomic variablesvariables

Examples:Examples:Hong Kong: Single equation aggregate estimate Hong Kong: Single equation aggregate estimate and panel estimates using bankand panel estimates using bank--byby--bank databank data

Denmark: Robust VaR over business cycle in Denmark: Robust VaR over business cycle in datadata--restricted environmentrestricted environment

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Credit Risk ScenariosCredit Risk ScenariosDepending on specific (macroeconomic) circumstances of the country, and data availability:

• NPL & loan provisioning (most countries), e.g.,NPL migration analysis/loan reclassification.

• Sophisticated analysis on PDs and LGDs,(including effect from macro factors).

• Specific: Cross-border lending (e.g., Austria), Foreign exchange lending (e.g., Jamaica), Loan concentration (e.g., Netherlands, Russia).

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Market Risk Market Risk

• Relatively well addressed through prudential supervision—often implemented using internal models

• Correlation of market and credit risk through indirect credit risk often not covered well.

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Market Risk: Type of AnalysisMarket Risk: Type of AnalysisInterest rate risk analysis:

• Repricing/Maturity Gap (e.g., Hungary)

• Duration (e.g., Czech Rep, Israel)

• Value at Risk (e.g., Belgium, Italy)

Exchange rate risk analysis:

• Net open position (e.g., Bulgaria, Sweden)

• Value at Risk (e.g., France, Germany)

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Market Risk: ScenariosMarket Risk: Scenarios•• Ad hoc, hypothetical, or historical interest rate Ad hoc, hypothetical, or historical interest rate

increase:increase:-- Parallel shift in yield curveParallel shift in yield curve-- Steepening/flattening yield curveSteepening/flattening yield curve

•• Ad hoc, hypothetical, or historical devaluation/ depreciation/appreciation

•• Basel Committee Amendment to Basel Committee Amendment to Capital Accord Capital Accord to incorporate market riskto incorporate market risk

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Liquidity Risk and Equity, Real Liquidity Risk and Equity, Real Estate Price ShocksEstate Price Shocks

Liquidity Risk:

• Change liquidity ratio, either ad hoc (Austria, UAE), or based on historical data (France, Croatia)

Equity/Real Estate Risk:• Shock to stock market (e.g., Finland, South Africa)• Housing Price Shock (e.g., Hong Kong, Ireland)• LTV ratios, mortgage PDs (e.g., Belgium, Australia)

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Other RisksOther Risks

• Commodity prices (e.g., Finland, New Zealand)

• Country exposure risk (e.g., Luxembourg)

• Shocks to specific sectors (e.g., Belarus, New Zealand: Agriculture; Finland: ICT)

• Interbank contagion (next slide)

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Contagion RiskContagion Risk•• Complementary to stress tests of individual institutionsComplementary to stress tests of individual institutions•• May highlight some vulnerabilities of the systems in May highlight some vulnerabilities of the systems in

addition to simply the effect of common shocksaddition to simply the effect of common shocks•• Methodology: Matrix of institutionMethodology: Matrix of institution--toto--institution institution

exposuresexposuresTypically net uncollateralized interbank lendingTypically net uncollateralized interbank lendingPayments systems exposures, ownership linksPayments systems exposures, ownership linksCould also be constructed for liquidity contagion based Could also be constructed for liquidity contagion based on experience from past runson experience from past runsExtreme Value Theory coExtreme Value Theory co--exceedances?exceedances?

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Issues Going ForwardIssues Going Forward

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Going ForwardGoing Forward——MethodologiesMethodologiesFurther develop methodologies:Further develop methodologies:

•• Credit risk analysisCredit risk analysis•• Correlations between market, liquidity and Correlations between market, liquidity and

credit risk credit risk •• ContagionContagion•• CrossCross--border issuesborder issues•• 22ndnd round effects, financial round effects, financial macromacro•• Reaction functionsReaction functions•• Conglomerates/Insurance Companies (other Conglomerates/Insurance Companies (other

NBFIs?)NBFIs?)•• Operational risk (?)Operational risk (?)

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Going Forward Going Forward -- FSAP ProcessesFSAP Processes““No one modelNo one model”” Need to better integrate Need to better integrate stress tests and analysis of other indicators.stress tests and analysis of other indicators.

Improving availability and quality of FSIs (coordinated Improving availability and quality of FSIs (coordinated compilation exercise); compilation exercise);

““benchmarkingbenchmarking”” of FSIs, links among FSIs and to other of FSIs, links among FSIs and to other indicators.indicators.

More explicit sectoral balance sheet analysis; More explicit sectoral balance sheet analysis; More explicit use of market indicators, and analysis More explicit use of market indicators, and analysis

thereof.thereof.Awareness of what the tests are not testing for (data Awareness of what the tests are not testing for (data

and model limitations, potential structural breaks and and model limitations, potential structural breaks and nonlinearities)nonlinearities)

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Going ForwardGoing Forward——FSAP Processes (2)FSAP Processes (2)

Balance between uniformity versus caseBalance between uniformity versus case--byby--case approach in FSAPs. case approach in FSAPs.

Further identify good practices for FSAPs. And Further identify good practices for FSAPs. And useful more broadly? useful more broadly? ““TemplateTemplate”” for small, lessfor small, less--complex financial complex financial systemssystemsDialogue with people at supervisory agencies Dialogue with people at supervisory agencies and central banks (e.g., Bundesbank web and central banks (e.g., Bundesbank web platform following last yearplatform following last year’’s forum at IMF)s forum at IMF)