Macro Stress tests in a simplified spreadsheet approach Mindaugas leika

Contents Balance sheet STs: basics Simple Balance Sheet ST model: Stress Tester v2 (Cihak, 2007) Case study from the WP: Bankistan Questions: ST scenarios Questions: ST results

Balance sheet STs: basics (1) Under balance sheet approach, we stress banks’ assets, liabilities, income and expenses. This is data intensive approach, however allows us to have detailed analysis and assumptions of various items on balance sheet and P&L statements. We calculate capital as follows:

Balance sheet STs: basics (2) Loan loss provisions; Forecasted from satellite credit loss model Net income before loan loss provisions; Forecasted from satellite income model Current Tier I and II capital (regulatory capital) Current RWA for: credit, market and operational risks Satellite credit growth model Loan loss provisions; Forecasted from satellite credit loss model Migration matrices

Static vs. dynamic approach Dynamic STs take into account previous quarter P&L statement and applies results to generate the next quarter’s balance sheet and so on. We model both, income statement and balance sheet. Static approach ,might be used to compare forecasted quarter's results with the base quarter. In dynamic framework we see, whether a bank is above CAR at any given point in time or not, while under static approach we might miss some periods where bank has CAR below target as losses/profits are non-cumulative. Static framework shows us the difference between the forecasted period and the base period.

Static vs. dynamic approach Starting Balance sheet Q0 Profit and loss statement Q1 Balance sheet Q1 Profit and loss statement Q2 Balance sheet Q2 Profit and loss statement Q3 Static approach Starting balance sheet Q0 Profit and loss statement Q1 Profit and loss statement Q2 Profit and loss statement Q3

Stress Tester v2 Features Very simple, beginner’s framework, though good starting point One period model. By default, assumes annual input data No satellite models Assumptions, shock scenarios have to be calibrated outside of the framework Contains the following worksheets: Read Me, Data, Assumptions, Credit Risk, Interest Risk, FX Risk, Interbank, Liquidity, and Scenarios Color scheme:

Stress Tester v2 Features Variables which can be stressed in the model: Capital – capital on terms of $ Capitalization – CAR (equity to assets, equity to RWAs) Capital injection – absolute number and in terms of GDP Profits – net income before and after provisions Profitability – return on assets, equity (ROA, ROE) Net interest income Z-scores – default probability and distance to default Loan losses – provisions Liquidity indicators Ratings and PDs

Link between CAR and PD in the excel file Source: Cihak, WP07/59

Case: bankistan (1) The economic environment in which banks are operating in Bankistan is challenging, with increasing macroeconomic imbalances, inappropriate macroeconomic policies, and deep uncertainty fueled by political tensions. Real activity is sharply contracting, and inflation has almost doubled to 65 percent. Unsustainable fiscal imbalances and loose monetary conditions were key to the deteriorating situation in Bankistan. The government deficit more than doubled in 2005, and a sharp increase in central bank financing of the government has significantly accelerated money growth. The policy response to the deteriorating situation has been inappropriate. Expansionary monetary policy measures (e.g., a lowering of reserve requirements) have induced a further easing of liquidity conditions. The ensuing excess liquidity induced a drop in treasury bill rates from 60 percent to below 15 percent. This means that together with an inflation rate of 65 percent, real interest rates are sharply negative. (Note: This is used for assessing interest rate risk.) Source: Cihak, WP07/59

Case: bankistan (2) The official exchange rate of the Bankistan currency, Bankistan dollar (B$), is fixed at 55 B$/US$. However, the black market exchange rate has depreciated in recent months from about 60 B$/US$ to about 85 B$/US$. (Note: This is important information for assessing foreign exchange risk.) The deteriorating macroeconomic environment has put considerable strain on the financial condition of the banking system. Even though the system has proved so far to be remarkably resilient, some banks have been weakened considerably, and are prone to further deterioration in light of the significant risks. Reported high capital adequacy ratios were found to be overstated due to insufficient provisioning. (Note: This information is used for the assessment of asset quality.) In addition, asset quality has deteriorated. The ratio of gross nonperforming loans (NPLs) to total loans has increased from 15 percent at end-2004 to 20 percent at end-2005. (Note: This information will be used for assessing credit risk.) Source: Cihak, WP07/59

Case: bankistan (3) The banking system of Bankistan consists of 12 banks. Three of them are state owned (with code names SB1 to SB3), five are domestic privately owned banks (DB1 to DB5), and four are foreign- owned (FB1 to FB4). The banking system, and particularly the state-owned banks, have been plagued by a large stock of NPLs and weak provisioning practices. Data on the structure and performance of the 12 banks are provided in the “Data” sheet of the accompanying Excel file. An assessment of Bankistan’s compliance with the Basel Core Principles for Banking Supervision (BCP) suggests that even though existing loan classification and provisioning rules in Bankistan are broadly adequate, they are not well implemented in practice and banks are underprovisioned. Source: Cihak, WP07/59

Case: bankistan (4) Given that Bankistan as an emerging market country faces more risks than an industrial country, it is appropriate to require from banks a higher CAR. Based on these considerations, Bankistan’s supervisors use a minimum CAR of 10 percent. Whenever the CAR of a bank in Bankistan falls below 10 percent, its owners are obliged to inject capital in order to stay in business.

Key issues for discussion: scenarios (1) a) Based on economic environment in Bankistan, which risks you think are most important and plausible? Shock matrix High probability Low probability High impact Main focus Watch Low impact Summary mention Ignore

Key issues for discussion: scenarios (2) b) What is the size of shocks? c) Which shocks are related?

Key issues for discussion: credit risk Credit shock 1 (“Underprovisioning”) (1) Which banks would be undercapitalized or even insolvent after applying the provisions? (2) How much capital would the government need to inject in order to bring the capital asset ratio of the undercapitalized/insolvent banks up to the required minimum of 10 percent? Questions are from Cihak (2007) IMF WP 07/59

Key issues for discussion: credit risk Which banks can not withstand a 25 percent increase in NPLs and will be undercapitalized or fail in this event? (3) How much capital would the government need to inject in order to bring the capital asset ratio of the undercapitalized/insolvent banks up to the required minimum of 10 percent? (4) What happens if only assets with a risk-weight of 0 percent, i.e. government bonds, would be affected? (5) Discuss alternative assumptions regarding the increase in NPLs and how these can be implemented.

Key issues for discussion: interest rate risk (6) Which banks can withstand the increase in interest rates and which would fail? (7) What are the associated potential costs for the government given the failure of banks in times of stress? (8) What are the weaknesses of the interest rate risk calculations and how can they be remedied?

Key issues for discussion: exchange rate risk (9) Which banks can withstand the shock and which would fail or be undercapitalized? (10) What are the associated potential costs for the government given the failure of banks in times of stress? (11) How does the inclusion of the indirect FX risk change the result of this stress tests? (12) How can the incorporation of the indirect FX risk be made even more realistic?

Key issues for discussion: contagion risk (13) How would you calculate the impact of the third iteration in the “pure” contagion exercise? (14) How would you incorporate banks’ profits into the exercise? (15) How would you reflect in the exercise the fact that banks with positive, but small, capital adequacy ratios can also fail?