1. Financial Crisis Lessons Learned and Policies Aimed at Strengthening the Resilience of the Banking Sector
Nora Manova Trajkovska
Senior Adviser Analyst
Financial Stability Unit
Financial Stability, Banking Regulations and Methodology Department
23rd Annual BSCEE Conference, Ohrid, Macedonia 15-17, June 2010

2. Agenda Financial crisis overview
Macedonia – macroeconomic and financial sector profile
Macedonia and the crisis
Importance of the stress-testing
Stress-testing at the NBRM
Conclusions

3. About the Recent Financial Crisis
Each crisis has its own unique set of characteristics
Unwritten rule: often the next crisis will emerge from an a sector or a region where we least expected it

4. The Achilles’ heel of the Pre-Crisis Global Financial System
The pre-crisis financial system was characterized by the following weaknesses:
too much leverage in the banking and financial system and not enough high quality capital to absorb losses
excessive credit growth based on weak underwriting standards and under pricing of liquidity and credit risk
insufficient liquidity buffers and overly aggressive maturity transformation, both direct and indirect (for example, through the shadow banking system)
inadequate risk governance and poor incentives to manage risks towards prudent long term outcomes, including through poorly designed compensations systems
inadequate cushions in banks to mitigate the inherent pro-cyclicality of financial markets and its participants
too much systemic risk, interconnectedness among financial players as well as common exposures to similar shocks, and inadequate oversight that should have served to mitigate the too-big-to fail problem

5. What We Have Learned?
For Regulators and Supervisors following lessons emerge:
First, there is a need to refine the regulatory framework to avoid distorted incentives
Second, supervisors and regulators need to have the incentives and resources to look hard and deep at possible flaws in the risk management systems of the institutions they oversee
An important third set of lessons relates to how to cope with the outcomes of crises of this new type

6. Financial Sector Reform Agenda
Reform agenda must be focused on all four key pillars of financial system stability:
Sound regulation
Effective supervision
Good governance and risk management in financial institutions
Appropriate resolution frameworks

7. Regulations
For the financial and regulatory framework, there are five areas that should be on top of the reform agenda for regaining financial stability:
Increasing the quantity and quality of capital and liquidity in the banking system
Expanding the regulatory perimeter to cover all systemically important institutions, markets, and activities
Dealing with excessive pro-cyclicality in the financial system
Improving financial disclosure
Ensuring more effective cross-border regulation, supervision, and resolution of systemically important institutions like those too big to fail

8. Supervision
Regulation has to be accompanied by a strong supervisory regime… we cannot rely on rules alone
The supervisors need to have clear objectives and mandates, operational independence and adequate resources
An appropriate mix of supervisory approaches and techniques, including on and off-site work focusing on identifying emerging risks at the firm level and system-wide
A wide range of remedial actions that can be taken if regulated firms do not play by the rule

9. Risk Management and Governance
Institutions need robust internal risk management systems accompanied by a culture of strong corporate governance in the individual institutions
Board oversight of risk management policies and processes is the foundation of the bank’s internal defense mechanism
The board is expected to determine the risk appetite of the firm, nurture the appropriate risk culture in the light of the firm’s risk profile, and assure that the bank does not take on excessive risk

10. Resolution
Having appropriate resolution mechanisms for failing institutions, particularly to deal with systemically important firms
Regulators could find ways to “discourage” institutions from becoming “too important to fail” by either imposing additional capital requirements based on their contribution to systemic risk, or by applying a leverage ratio on a group wide basis and heightened supervisory oversight

11. The Macroeconomic Profile of Macedonian Economy Amidst Crisis
Mild contraction of the economy on the backdrop of the crisis (0.7% real GDP fall), partly as result of prudent policies and not having large imbalances prior to the crisis ...Moderate recovery expected in 2010, with GDP growth being forecasted at 1%
Labor market resilient to the economic contraction, but unemployment rate extremely high (around 32%), mirroring structural problems
After the pickup in inflation in 2008, pressures receded in 2009, amidst falling import prices and subdued demand (-0.8% average inflation)...In 2010, inflation to be held in interval of 1%-1.5%, driven by supply side factors
Sharp downward adjustment of CAD in 2009 (leveled at 7.3%, compared to 13% of GDP in 2008), implied by the falling demand and lower energy prices...CAD to gravitate around 6% of GDP in 2010
Capital inflows slowed, but abundant enough to enable accumulation of reserves...same pattern expected in 2010, thus keeping foreign reserves at comfortable level
External indebtedness increased in 2009 by 7 pp of GDP (gross external debt/GDP of 57.9% of GDP), but it is still at a relatively prudent level and with favorable structure (large share of intercompany lending and trade credits)

12. Financial Sector Overview (1)
Financial intermediation picked up during last several years …72.2% (68.2%-2008)
Bank-driven system, banks comprise around 90% of financial system assets and their main business focus is collecting deposits and granting loans
Non banking financial institutions have minor systemic importance, low level of financial innovations

13. Financial Sector Overview (2)
Increased (but still low) turnover of inter-bank market during last year, and illiquid secondary short-term securities’ market
Domestic companies are not involved in issues of long term securities (non active primary capital markets)
In the course of 2009 domestic investor have had larger impact on the capital market developments due to the passive performance of foreign investors and their withdrawal from the market …. in the previous years the stock exchange movements were highly influenced by the behavior of foreign institutional and individual investors

14. Stable Banking System in the Time of Crisis (1)
The banks in the Republic of Macedonia proved to be prudent in their operations and managed to remain stable
Banking system is consisted of 18 banks and 10 savings houses
Total sector assets around EUR 5 billion
Further deepening of financial intermediation, 66% at the end of 2009 (62.9% at the end of 2008)
14 banks dominantly owned by foreign shareholders (mainly from EU countries) representing 93% from the total banking system assets
Banks’ solvency remains relatively high – CAR 16.4% (8% legally prescribed minimum)

15. Stable Banking System in the Time of Crisis (2)
Mainly domestic funding (deposits of non-financial entities are around 70% of total assets; around 98% are resident deposit; 67% are household deposits)
Loan to deposit ratio almost unchanged- 92.5% (2009), 92.8% (2008)
Stable liquidity position (share of liquid assets in the total assets equaled 25.7% and provides satisfactory level of coverage of household deposits -53.7%, as well as, of the short term obligations %)

16. Stable Banking System in the Time of Crisis (3)
The dynamics of banks’ lending activity decelerated (34.4% - annual growth rate of credits to non-financial entities for 2008, while at the end of 2009 this growth rate was reduced down to 3.5%)
Credit risk the most important risk in Macedonian banks operations
The share of non-performing loans in total loans is 9.1%-2009 (6.8% at the end of 2008)
Indirect credit risk is highly present (60% of loans are indexed to foreign currency and about 85% of total loans are with adjustable interest rate)
Banks’ profitable operating continued in 2009, although at a lower level compared to the previous year

17. Was the Macedonian Banking System Affected by the Global Financial Crisis? (1)
Macedonian banking system remained stable and resilient after the first wave of the global financial crisis
Global crisis had no direct negative effects on the banks in Macedonia due to several factors:

18. Was the Macedonian Banking System Affected by the Global Financial Crisis? (2)
Relatively high “closure” of the Macedonian banking system relative to the global financial flows and focus on domestic market
Its conservativeness, i.e. its orientations towards traditional banking activities (collecting of deposits and placement of loans
Macedonian banks are not exposed to subprime, structured credit derivatives and other related complex products and they had no credit exposure to the financial institutions affected by the crisis
Low dependence on foreign sources of financing

19. Was the Macedonian Banking System Affected by the Global Financial Crisis? (3)
Even though, some indirect effects especially in the course of 2009 were evident – through following channels:
Real sector
Psychologically induced pressures
Limited access to finance for the banks

20. NBRM Measures to Enhance the Banking Sector’s Resilience to Stress (1)
Tightening of the treatment of the banks’ claims on the basis of credit cards and overdrafts when determining the banks’ solvency (increase in the weight from 100% to 125%)
Limiting the risks of the rapid household credit growth by introducing an obligation for allocation of compulsory deposit by banks and savings houses within NBRM, in case of higher growth of the household credits than the allowed growth rates
Intensified contacts with banks
Lowering the limit for the exposure to the first-class banks

21. NBRM Measures to Enhance the Banking Sector’s Resilience to Stress (2)
Daily monitoring of the level of the households’ deposits within banks in the Republic of Macedonia
Setting the minimal liquidity level required for covering of the bank’s liabilities that will due in the next 30 and 180 days, individual for Denar and foreign currency
Possibility for banks foreign currency assets to be deposited within NBRM instead of their placement in the foreign banks’ abroad

22. Stress Tests and Crisis - What We Have Learned?
What have stress tests shown us?
Often, stress tests did not stress the right areas or not enough
But, …. stress test should be catalyst for further analysis

23. Increased Interest in Stress - Testing
Increased importance of stress-testing, especially as a consequence of the current turmoil
At the level of individual financial institutions, stress-testing should be part of their internal risk management and should supplement other risk management approaches and measures
At macro level, stress-testing should help regulators address structural vulnerabilities and overall risk exposure in a financial system
In our country, the main promoter of the stress test was the IMF with its FSAP mission in 2003

24. Stress-Testing of Banking System
Particularly deterministic stress test
Scenario analysis and sensitivity tests
Micro and macro perspective
Stress tests at individual banks (bottom-up approach)
Stress tests at NBRM (top-down approach)

25. Stress-Testing at Individual Banks
Banks are required, at least annually to conduct stress test for their most important risk factors
Through stress tests banks assess the shocks’ effects on CAR, profitability position and credit portfolio
Reporting to Risk Management Committee and/or other governing bodies
Notification to NBRM on the stress test results
In 2008, during FSAP mission bottom-up stress tests were performed by few large banks

26. Stress-Testing at the NBRM (1)
Used for macro prudential analysis and shock absorption capacity
Conduct on quarterly basis – standard tests and ad hoc simulations
High-degree of conservatism in assumptions (extreme shocks)
Measuring effects on aggregated basis and for individual institutions (simplicity, one round effects, low time consumption)

27. Stress-Testing at the NBRM (2)
Partial publication of results in different NBRM reports
Some of the reports are submitted to the management and to the NBRM Council for review and adoption
Stress –test conducted on individual banks are shared with the relevant portfolio manager in the Off-Site Supervision Department and with the management of the On-Site and Off-site Supervision Department

28. Variety of Stress Test Simulations
Stress-test simulations for the resistance of the banking system and individual banks to following hypothetical shocks on:
Isolated credit risk on overall credit portfolio
Combination of credit risk, foreign exchange rate and interest rate risk
Different credit portfolio segments
Concentration risk
Liquidity risk

29. Additional Stress Test Simulations
On ad hoc basis:
Combination on liquidity and credit risk (bankruptcy of international active banks)
Stress Test Simulations for the Resistance of the Banking System to the Shocks Connected with the Debt Crisis in Greece

30. Isolated Credit Shock and Combination of Credit, Foreign Exchange and Interest Rate Shock (1)
This stress test analysis is based on the application of eight hypothetical simulations:
Three simulations for isolated credit shock (increase in the credit exposure in the risk categories C, D and E by 10%, 30% and 50%)
Fourth simulation as a combination of the credit and interest rate shock (increase in the credit exposure in the risk categories C, D and E of 30% and increase in the domestic interest rates of 5 percentage points)

31. Isolated Credit Shock and Combination of Credit, Foreign Exchange and Interest Rate Shock (2)
Fifth scenario as a combination of credit and foreign exchange shock (increase in the credit exposure in the risk categories C, D and E of 50% and depreciation in the Denar exchange rate compared to the Euro and the US Dollar of 20%)
Sixth simulation as a combination of shocks on the side of the credit risk, the foreign exchange risk and the interest rate risk (increase in the credit exposure in the risk categories C, D and E of 50%, depreciation of the Denar exchange rate compared of the Euro and the US Dollar of 20% and increase in the domestic interest rates of 5 percentage points)

32. Isolated Credit Shock and Combination of Credit, Foreign Exchange and Interest Rate Shock (3)
Seventh simulation, appreciation of the Denar exchange rate relative to the Euro and the US Dollar in the amount of 20%
Eight simulation (increase in the credit exposure in the risk categories C, D and E of 50%, depreciation of the Denar exchange rate compared of the Euro and the US Dollar of 20%, increase in the domestic interest rates of 5 percentage points and increase of Euribor and Libor of 2,5 percentage points)

33. Isolated Credit Shock and Combination of Credit, Foreign Exchange and Interest Rate Shock (Results)

34. Shocks on Different Credit Portfolio Segments
Shock – gradually worsening of the credit portfolio quality, by individual activity or by each credit products offered to households by applying two scenarios:
Migration of 10% of the credit exposure of each risk category to the next two higher risk categories, distributed equally
Redistribution of 30% of the credit exposure of each risk category to the next two higher risk categories
Purpose: potential adverse effect of the credit exposure migration (for both the total exposure and the exposure by sector and activity) from the existing to the higher risk categories on the capital adequacy and the exposure risk
Results as of March 31, 2010:
Entire credit portfolio: CAR 16.7% (before shock) % (after I scenario) and 10.6% (after II scenario)
Exposure to households: the largest impact on CAR emerges from exposure on the basis of consumer loans and credit card loans
Exposure to corporate sector: industry and wholesale and retail trade are activities with the largest influence on CAR

35. Concentration Risk
Simultaneous reclassification in the risk category C of the five largest credit exposures to non-financial entities, including connected entities
Size of shock: impairment of total credit exposure
Results as of March 2010:
CAR from 18.4% to 15.4%

36. Liquidity and Credit Risk Simulations
Testing on domestic banks’ resistance on bankruptcy of international active banks:
Default of foreign parent entity of domestic bank
Default of a large foreign correspondent financial institution
Measurement of effects on CAR and on profitability
Assessment of effects on liquidity
Results: Larger effects on liquidity than on CAR and profitability

37. Stress Test Simulations for the Resistance of the Banking System to the Shocks Connected with the Debt Crisis in Greece
Two transmission channels:
domestic legal entities net exporters to Greece
domestic legal entities debtors to Greece
Two simulations:
Moderate
Extreme
Results: relatively high resistance of the Macedonian banks’ to the plausible adverse effects from the debt crisis in Greece

38. Stress Test Simulations for the Resistance of the Banking System to the Shocks Connected with the Debt Crisis in Greece

39. Conclusions – Financial Crisis (1)
We certainly hope the worst is behind us
The crisis has hit ordinary people very hard
Regulators should restore the trust in the financial system and the financial stability framework through set of policies
Lessons from the crisis should be drawn and applied through policies
Modest reforms that maintain a pretense of progress but continue business as usual are not sufficient

40. Conclusions – Financial Crisis (2)
Corrective action is still needed and the lessons we are learning are ongoing
Stress testing is important risk management tool for further analysis
Banks must have a comprehensive stress tests for counterparty credit risk

41. Conclusions – Financial Crisis (3)
Macedonian banking system remained stable and resilient after the first wave of the global financial crisis
Global financial crises had no direct negative effects on the banks in Macedonia

42. Conclusions – Financial Crisis (4)
If regulatory standards had been higher, as the BCBS in now proposing, the crisis would have been less severe and the burden on the public sector and taxpayers would have been lower
Banking system remains essential for the recovery and for long-term prosperity
As a regulators our mandate is to make it function properly!

43. Sources

44. Thank you for your attention!