1. MACRO STRESS TESTING Charles Augustine Abuka

2. Introduction One of the key issues in the recent financial crisis was that stress testing was not an integral part of regulators’ decision-making process. Stress testing exercises conducted by central banks in most of the cases failed to reveal systemic risks nor led to any macroprudential actions. During the global financial crisis many of the central banks moved toward an integrated approach and designed full scale macro scenario based stress testing exercises that involved central banks, supervisory agencies and market participants. Countries in the COMESA region need to develop integrated stress testing frameworks for use in forward looking risk based financial stability analysis. 1

3. Introduction Stand alone models are not sufficient for successful completion of stress testing exercises; A comprehensive framework and cooperation among various departments is a key prerequisite to success. Integrated stress testing frameworks allow staff to make better judgment about capital adequacy of the whole banking system and of individual banks in particular. The integrated stress testing frameworks integrate the whole stress testing process, from scenario design to use of results for micro and macroprudential purposes. The key benefit of integrated approach lies in its holistic view: – Risk identification, – Scenario design, – Application in stress testing models and justification of policy responses. 2

4. MACRO STRESS TESTING FOR COMESA COUNTRIES 3

5. Introduction Stress-testing as a framework for forward-looking analysis of systemic risks has developed great appeal among central banks across world. Why should Macro Stress testing be conducted? – Assesses vulnerability of a financial system to ‘exceptional but plausible’ macroeconomic shocks, – Part of the arsenal of forward looking macroprudential tools. 4

6. Experience of Macro Stress Testing in COMESA  Top down approach  Bottom up approach – The stress testing frame work: The five stage process – Initial shock -> interaction of risk drivers-> mapping defaults into losses, process of borrower defaults, earnings of the financial sector-> impact on P&L and capital of the financial sector Feedback effects on economy and markets. 6

7. Stylized steps for developing a macro stress testing framework Step 1: Assessing pre-requisites, Step 2: Deciding the framework for calculations, Step 3: Determining the risks and the corresponding size of shocks, Step 4: Expanding to assess inter-linkages including cross- border risks, Step 5: Forming a stress testing working group (STWG), Step 6: Deciding the frequency of conducting stress tests, Step 7: To develop a macro-financial stress testing model in the long run. 8

8. Stylized steps for developing a macro stress testing framework Step 1: Assessing pre-requisites  Who will conduct stress-testing?  Is data available?  What is the frequency of data available?  What are the data gaps?  How are scenarios designed and assumptions underlying them chosen?  How are results interpreted and acted upon?  Lack of data is a major hindrance to stress testing in COMESA Countries 9

9. Stylized steps for developing a macro stress testing framework Step 2: Deciding the framework for calculations Where data allows, econometric regressions can be run to estimate elasticities of banking performance variables such as NPL ratios to the changes in macroeconomic variables, primarily GDP. In developing countries with major structural upheavals in the recent past or with a fledgling financial industry may not be able to ascertain any robust relationships between macroeconomic and banking variables. In these cases, it is beneficial to develop a longer time series of data over the long term while focusing on micro stress testing efforts in the short term. 10

10. Stylized steps for developing a macro stress testing framework Step 3: Determining the risks and the corresponding size of shocks, The sizes of shocks used for scenarios should be calibrated using historical and/or ad-hoc assumptions. Shock parameters for market risk can be calibrated using historical data. A multiple of the standard deviations are good ad hoc shocks to interest rates and exchange rates. The size of shocks applied should be sufficiently severe yet plausible. Liquidity and credit risks can be combined into a single shock scenario to make the simulated crisis more realistic. 11

11. Stylized steps for developing a macro stress testing framework Step 4: Expanding to assess inter-linkages including cross-border risks. A common COMESA stress testing exercise might be meaningful once the level of financial integration and inter-linkages among financial institutions substantially increases from the current level. Financial inter-linkages and cross-border exposure of banks within each economy have to be taken into account. These are still very low. Direct contagion risk in the region is low, albeit “psychological contagion” is possible. Therefore, at this stage, COMESA economies should focus on developing a framework for assessing risk on interconnection and contagion within their own financial sectors, rather than regionally. 12

12. Stylized steps for developing a macro stress testing framework Step 5: A Stress Testing Working Group (STWG). A WG consisting of representatives of all the relevant departments in the central bank and the other regulatory authorities may be established with the following primary tasks: – Development of methodology, scenarios and aggregation of results. The WG prepares two scenarios: Baseline and Adverse. – During the STWG’s meetings data are discussed and shared among members. – The STWG also decides about common risk factors for the region as well as individual countries and proposes common adverse scenario, designs common stress testing templates. 13

13. Stylized steps for developing a macro stress testing framework Step 6: Deciding the frequency of conducting stress tests. It is advisable to conduct liquidity stress tests on a monthly basis and credit stress tests on a semi-annual basis. Credit risk does not tend to change as quickly as liquidity risk. Therefore, conducting credit risk stress testing on a monthly or quarterly basis, as is currently the practice in some countries, may not add much value. Instead, it absorbs resources that could be used in analyzing and developing a more sophisticated and integrated stress testing framework. 14

14. Stylized steps for developing a macro stress testing framework Step 7: To develop a macro-financial stress testing model in the long run. Countries need to develop a macro-financial stress testing models using their national macro forecasting model projections as inputs into it. Problems with quality of macro and absence of real estate, household and corporate financial accounts data prevents the COMESA countries from developing sophisticated macro financial stress testing models. – Their results are usually not robust – In many cases can only be used to explain past behaviour of NPLs but not to forecast future developments. However macro financial stress testing models can be used for story- telling, i.e. describe shock transmission channels. 15

15. An Initial framework for Stress testing banks To implement this framework staff in COMESA member central banks need to have a broad understanding of their economies and their financial sectors. They have to identify a number of vulnerabilities in their banking systems. They should be able to construct a relevant set of trigger events to probe the importance of these vulnerabilities. The framework employs a top-down approach to stress testing. Balance sheet and income statement data should be available for the largest banks in the country, which account for highest proportion of total banking assets. Initially countries can focus on four main financial risk factors – interest rates, exchange rates, credit quality, and liquidity. 16

16. An Initial framework for Stress testing banks A set of macro shocks are translated automatically into changes to bank balance sheets. – Changes in interest rates and exchange rates have a direct effect on banks’ balance sheets, – The sign and size of these changes depend on the characteristics of banks’ portfolios. Changes in interest rates, exchange rates, GDP growth, and the unemployment rate also have indirect effects on bank balance sheets as a result of any change in credit quality. The results of the stress test can be summarized with graphs that: – (i) Compare the post shock capital adequacy ratios (CAR) of various categories of banks with their CARs under the pre-shock scenario; – (ii) Present the amount of capital as a percent of GDP that will be necessary to recapitalize banks; – (iii) Assess the systemic importance of the test by illustrating the concentration of “bad assets” in the banking system, by bank category 17

17. Mapping Macro Shocks to Changes in Credit Quality Mapping changes in the macro environment into changes in bank capital is a complex process. Why? – Very detailed information on the asset and liability positions of banks is necessary in order to understand how changes in market interest rates and exchange rates will affect bank portfolios. – Additional information about borrowers (amount and quality of collateral, hedging strategies, income and wealth) is needed to understand their ability or willingness to meet loan obligations. – One also needs to understand how banks and bank supervisors will react to adverse economic changes. 18

18. The Integrated Macro Stress Testing Framework The integrated stress testing frameworks could consist of the following elements : – A STWG – The definition of purpose and use of stress tests. – The frequency and coverage of the financial system. – The assumptions and scenario design. – The estimation of links between shocks and losses. – Calculation of capital adequacy. – Identification of the transmission channels and feedback effects on financial system. – The macroprudential policy implications. – The communication policy. 19

19. The Integrated Macro Stress Testing Framework The primary users of stress testing results are the senior management of the macroprudential authority that makes policy. Senior policy makers should be engaged in stress testing process: – They should rely on its results while making macroprudential and Microprudential policy decisions. Stress testing should be aimed at policymakers’ needs and provide support to their decisions. 20

20. The Integrated Macro Stress Testing Framework Macro scenario design should focus on these issues: – Identification of structural weaknesses in the economy, – Identification of global market trends, – Identification of weak individual institutions. 21

21. The Integrated Macro Stress Testing Framework Elements of a credible scenario design include multiple risk factors and assumptions about individual risk factors pertinent for each institution included into exercise: – Credit risk – the impact of macro shocks on loan losses – Market risk – the impact of changes in the exchange rate, interest rate and asset prices – Liquidity risk – the impact of inflows and outflows of assets – Individual risks – large exposures, asset concentration, balance sheet behaviour 22

22. The Integrated Macro Stress Testing Framework Building Satellite models – Linking banks losses and income to various micro and macro factors. – For example linking NPLs with macro factors such as GDP growth and lending rates. Calculation of Capital Adequacy and interpretation of results. 23

23. The Integrated Macro Stress Testing Framework Further areas of improvement include: – Development of capacity to implement Next Generation and other Balance sheet based stress testing models: – Better scenario design and use of satellite models to get stressed NPLs; – Implementing scenarios based on real estate price shocks. Countries need to collect real estate prices, – Building satellite models for profitability, interest income and credit growth, – Improving liquidity stress testing and design of new reporting framework. Countries need to consider building joint credit and liquidity stress testing scenarios. 24

24. The Integrated Macro Stress Testing Framework The additional efforts that COMESA member states need to implement integrated macro stress testing include: – Formation of Stress Testing Working Groups, – Strengthening the involvement of high level policy makers in approval of scenarios and results, – Gathering more data, – Regular meetings between Financial Stability Units primary sources of data, – More effort required in mapping systemic vulnerabilities in the financial system. Scenarios have to be designed incorporating feedback effects and multiple sources of risk, Modelling efforts should be deepened to include profit and credit growth equations; Liquidity and credit risk stress tests should be linked; 25

25. The Integrated Macro Stress Testing Framework – Member state central banks sould define potential list of macroprudential policy tools which can be applied once stress tests reveal vulnerabilities in the financial system; – Communication policy needs to be designed to inform what goes into the Financial Stability Reports. 26

26. 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 27

27. References Oosterloo, S., J. de Haan, and R. Jong-A-Pin, 2007, "Financial Stability Reviews: A First Empirical Analysis", Journal of Financial Stability, No. 2, pp. 337–355. Quagliariello, M. (edited by) (2009), ‘Stress-testing the Banking System, Methodologies and Applications’, Cambridge University Press. Sorge, Marco, and Kimmo Virolainen (2006). "A comparative analysis of macro stress-testing methodologies with application to Finland." Journal of financial stability2.2 (2006): 113-151. Van den End, Hoeberichts and Tabbae (2006), ‘Modelling Scenario Analysis and Macro Stress-testing’, Working Paper No. 119/November 2006, De Nederlandsche Bank Wilson (1997), ‘Portfolio Credit Risk’, Risk, vol. 10, Issues 9-10. 28