1. 1 Methods and tools of macroprudential analysis the central bank’s perspective Piotr Szpunar

2. 2 Financial stability – general remarks Macroprudential analysis and the role of central banks How to conduct macroprudential analysis ? Stress-testing – types of stress tests and methods How to use the results ? The European context – the ESRB Agenda

3. 3 Financial stability – general remarks Macroprudential analysis and the role of central banks How to conduct macroprudential analysis ? Stress-testing – types of stress tests and methods How to use the results ? The European context – the ESRB Agenda

4. 4 What is financial stability? „…a situation when the system performs all its functions in a continuous and effective way, even when unexpected and adverse disturbances occur on a significant scale” Financial Stability Report, page 3. Lack of Financial Stability Disturbance in the provision of financial intermediation services Negative impact on the real sector Definition used by the NBP:

5. 5 Why should one look after financial stability? Financial stability is A PUBLIC GOOD Financial system prone to market failures Financial system as a transmitter of monetary policy of the central bank Stable financial system as a necessary condition for smooth functioning of the payment system Significant public costs of a financial crisis that results from a severe system instability

6. 6 What do we look at? Financial systems –Institutions (not only banks) –Markets –Infrastructure Tail events –Low probability –High impact Ideally – forward-looking financial stability analysis: identify today the risks that can materialize in the future and suggest policy countermeasures when necessary Necessary to coordinate with macroeconomic analysis X P(X)

7. 7 Financial system in the economy Households and enterprises Financial institutions: banks, insurers, asset managers Domestic financial markets Real sector shocks Foreign financial market shocks Lending, deposits insurance: Economic function Consumption smoothing, Savings/ Investment intermediation Savings/Investment intermediation through e.g. investment funds; market interest rates Financial market trading Infrastructure: systems, regulations…

8. 8 A „universe” of financial stability analysis Current situation of the banking sector Macro- economic shocks Assessment of potential loss & ability to withstand shocks Infrastructure Investment funds Insurers Pension funds Other financial institutions

9. 9 9 Financial Stability in transition economies Short history of the system in its current form –Short time-series and breaks: difficult to build models –Some financial products newly introduced Bank-dominated financial sector main focus on banks High share of foreign capital in the banking sector Important non-bank institutions: –Insurance companies –Pension funds and investment funds (with investment risk borne by clients) Important markets –FX –Treasury bonds –Equity market (but directly not important for banks due to small scale of investment in equities)

10. 10 Financial stability – general remarks Macroprudential analysis and the role of central banks How to conduct macroprudential analysis ? Stress-testing – types of stress tests and methods How to use the results ? The European context – the ESRB Agenda

11. 11 Macroprudential policy In general terms, the ultimate goal of macroprudential policy should be safeguarding financial stability At the operational level, the main objectives of macroprudential oversight should be prevention and mitigation of systemic risk Prevention of risks: –(1) analysis of the financial system –(2) early identification of risks –(3) remedial action The risk mitigation may be interpreted as making financial system more robust and resilient.

12. 12 Who should be in charge of macroprudential analysis? Mitigating systemic risks and preventing financial crises Micro-prudential approach (individual institution’s risks) Macro-prudential approach (systemic risk) Supervision authorityCentral Bank Macroprudential versus Microprudential approach

13. 13 Who should be in charge of macroprudential analysis? Key role of central banks due to: –Independence –Analytical capacity for systemic risk analysis –Data sources – not only on financial firms but also on the real economy – providing broader view –Monetary policy –Market intelligence CB being a market participant –Close cooperation with banks –Bank of banks – lender of last resort

14. 14 Financial stability – general remarks Macroprudential analysis and the role of central banks How to conduct macroprudential analysis ? Stress-testing – types of stress tests and methods How to use the results ? The European context – the ESRB Agenda

15. How to analyze financial stability? 15 Slowdown in EMU Worsening standing of parent entities Crisis contagion into EM Strict monetary policy due to high inflation Fall in prices real estate market High divident payments Large portfolio of household credits from the period of lenient lending policy High share of FX loans Higher share of funding via market Higher share of foreign and parent entities funding Higher cost and volatility of deposits Limited capital resources Credit losses Higher funding costs Lower interest income Capital adequacy Lending Implications For the real economy Profits National Bank of Poland’s approach

16. 16 Banking sector – what to look at? Lending and other functions of the financial system Real Economy Shocks Vulnerabilities Channels of impact Banks’ income, capital, funding Current situation of banks Macro- economic shocks and imbalances Assessment of potential loss & ability to withstand shocks Impact on welfare of society Financial market shocks

17. 17 Banking sector – what to look at? Lending and other functions of the financial system Real Economy Shocks Vulnerabilities Channels of impact Banks’ income, capital, funding Strengths and high-risk areas in the financial system Examples: - Lending policy and loan portfolio structure - Capital position - Exposures to market risk - Asset prices: real estate, shares… - Common exposures (macro vs micro perspective) - Funding structure Tools: indicators of financial system „health”, e.g. IMF’s Financial Soundness Indicators as a starting point (only!)

18. 18 Banking sector – what to look at? Lending and other functions of the financial system Real Economy Shocks Vulnerabilities Channels of impact Banks’ income, capital, funding Potential shocks to financial stability Examples: - Macroeconomic imbalances – e.g. inflation, current account deficit, fiscal deficit – which may lead to weaker future economic growth - Indebtedness of real economy - Materialisation of risk factors for industries with significant bank debt - Tensions in financial markets - Commodity prices Tools: macroeconomic analysis

19. 19 Banking sector – what to look at? Lending and other functions of the financial system Real Economy Shocks Vulnerabilities Channels of impact Banks’ income, capital, funding

20. 20 Banking sector – what to look at? Lending and other functions of the financial system Real Economy Shocks Vulnerabilities Channels of impact Banks’ income, capital, funding Impact on banks’ financial position - Can institutions withstand the shocks? - What is their capital, liquidity and profit position after the shock? Tools: stress tests

21. 21 Banking sector – what to look at? Lending and other functions of the financial system Real Economy Shocks Vulnerabilities Channels of impact Banks’ income, capital, funding Banks’ capacity to lend and risk appetite - Would banks change their lending policy as a result of shocks? - Does their capital and funding position allow to continue to provide lending? Tools: Most often expert assessments. Macroeconomic models with detailed financial sector modules are not common yet.

22. 22 Banking sector – what to look at? Lending and other functions of the financial system Real Economy Shocks Vulnerabilities Channels of impact Banks’ income, capital, funding Impact on consumption, investment, unemployment, economic growth… Tools: expert assessments in cooperation with macroeconomic analysts; e.g. residual adjustments in macro forecasting models

23. 23 Indicators of financial system health Backward-looking - based on accounting data Distributions matter –Aggregate data useful but loss of some information –Sector-wide trends or individual bank events –But do not replicate off-site examination What is behind the numbers –Quantitative benchmarks usually not very useful –Try to understand the economic process –Look at a number of indicators simultaneously –Qualitative information also important

24. 24 Products of financial stability analysis Financial Stability Reports –Main assessment of financial stability –Published every six months –Detailed analysis, including stress tests –Discussed and accepted by NBP Management Board –Main recipients NBP Management Board Monetary Policy Council FSA Interested public Senior Loan Officer Survey Ad-hoc work

25. 25 FSR structure Summary assessment of risk Economic environment of financial institutions –Macroeconomic trends –Financial market developments –Real estate market trends Banking sector –Earnings –Credit risk, including analysis of borrowers’ financial position –Market risk –Liquidity risk, including box on payment system developments –Capital and stress tests –Market assessment Non-bank financial institutions

26. 26 Financial stability – general remarks Macroprudential analysis and the role of central banks How to conduct macroprudential analysis ? Stress-testing – types of stress tests and methods How to use the results ? The European context – the ESRB Agenda

27. 27 What is a stress test (in general)? „A rough estimate of how the value of a portfolio changes when there are large changes to some of its risk factors”* Now a standard tool in risk management in financial institutions… althought the current crisis shows that it was probably not used enough * source: „Financial Sector Assessment, A Handbook”, IMF & World Bank, 2005

28. 28 What is a macro stress test? An attempt to (quantitatively) evaluate the resillience of a financial system to large but plausible shocks (low probability, high impact events) –What types of risk have the greatest influence? –What could be the impact of previously identified vulnerabilities and imbalances? –Are there common vulnerabilities across institutions that can undermine financial stability?

29. 29 How to measure the impact? Usually expressed as impact on indicators of financial system health, e.g. –Capital adequacy –Loan losses –etc… No universal measure of financial stability developed as yet… … so judgment plays a great role in the interpretation of results

30. 30 Macro stress tests – some „labels” „ad-hoc” „model-based” Impact on FSIs is based on econometric models Shocks to FSIs are assumed by analysts Possibly multiple risk factors, comovements from macro model or historical experience A single risk factor is shocked – can be a macro variable or simply an FSI „single factor” „sensitivity” „scenario”

31. 31 Macro stress tests – some „labels” Calculations done “in-house”, without engaging financial institutions Calculations performed by financial institutions, assumptions supplied by CB/supervisors „bottom-up” „top-down” These are done by the NBP

32. 32 Ad-hoc sensitivity stress tests Why to perform ad-hoc sensitivity simulations given the presence of more sophisticated macro stress-tests? 1.Isolation of the impact of specific risk factors 2.Ceteris paribus kind of analysis 3.Prioritization of risk factors based on their isolated impact 4.Opportunity to take advantage of data sources not included in macro stress-tests 5.Results easier to communicate 6.No need to specify joint distribution of risk factors which may be very challenging

33. 33 Ad-hoc sensitivity stress tests Ad-hoc nature –no specific macroeconomic scenario –no assigned probability of occurrence –scenarios chosen as (quite) extreme but plausible, based mostly on common sense, past crises can provide guidance Tracking changes in results over time is important

34. 34 Examples of ad-hoc stress-tests 1.Take a measure of risk in the financial system 2.Create a shock scenario, often on ad-hoc basis 3.Find the impact of shock on your measure of risk 4.Try to translate the measure of risk to FSIs (capital, earnings)

35. 35 Example – households’ income buffer Shock scenario –30% zloty depreciation –Increase of interest rates on loans by 400 basis points Results – example FSR December 2010: 30% zloty depreciation400 bp interest rates increase Increase in the share of households with negative income buffer Increase in the share of loans extended to households with negative income buffer Increase in the share of households with negative income buffer Increase in the share of loans extended to households with negative income buffer 1.21.21.51.53.23.23.73.7

36. 36 Example - „Stress-CAR” What impact can the existing portfolio of impaired loans have on capital adequacy of banks? What if value of loan security held for classified loans changes? (e.g. fire sale, overly optimistic valuation)

37. 37 Stress - CAR Assumption: Only collateral can be recovered for impaired loans 3 scenarios for changes in value of collateral Losses Change in capital adequacy

38. 38 Stress-CAR – results Importance of security for loss reduction Basel II implementation

39. 39 Stress-CAR – results Distribution of banks’ assets by „stressed” capital adequacy ratio

40. 40 Macro stress test Build macroeconomic stress scenario Calculate change in banks’ financial result relative to baseline scenario Calculate the changes in capital adequacy of individual banks Expert input Econometric models Decide on the source of shocks – ”story” Expert analysis Ad-hoc shocks Macro model Historical crisis e.g. recent macro forecast

41. 41 Constructing a macro stress test scenario – possible approaches Market forecasts –Take the most pessimistic forecast from surveys of market participants –Easy to communicate, but is it really extreme? Statistical –Look at fancharts of GDP growth and take an extreme pessimistic path (e.g. 5% probability) or look at residuals of forecasting model and choose an extreme shock from the distribution of residuals –Hard to communicate Expert scenario –What is pessimistic and economically consistent? –Open to criticism of subjectivity Historical scenario –What did the previous downturn look like? –Is it relevant?

42. 42 Macro stress tests - December 2010 scenarios Scenarios –Baseline: October projection NBP –Shock I: longer period of low economic growth in highly developed countries could lead to a fall in Poland's real GDP, further increased by a hypothetical pro- cyclical response of fiscal policy – GDP ca. 4.5 pp lower than baseline –Shock II: shock scenario I combined with fall in foreign investor confidence and additional shock for the Polish economy resulting in outflows of capital from Polish market of government bonds – GDP ca. 5.75 pp lower than baseline –Horizon – end of 2012, as in NBP macroeconomic projection Shock scenarios (red lines) on the back of October projections of GDP GDP y/y201020112012 Baseline3,5%4,3%4,2% Shock I3,4%2,4%2,0% Shock II3,4%2,1%1,1%

43. 43 Calculation of impact on banks Macro scenarios fed into panel data models to obtain forecasts of loan losses and net interest income for individual banks Costs and non-interest income assumed constant in relation to assets Calculation of changes in capital adequacy Comparison with baseline scenario

44. 44 Building blocks Additional assumptions Macro scenarios Credit risk cost forecastNet interest income forecast Banks’ earnings Change in capital adequacy ratios and estimates of recapitalisation needs Contagion effects

45. 45 Stress tests December 2010 Results Result Actual data 2009Q4 - 2010Q3 Baseline, per year over 2010Q4- 2012Q4 Shock scenario 1 per year over 2010Q4- 2012Q4 Shock scenario 2 per year over 2010Q4- 2012Q4 Impairment charges (PLN bn)11.02.25.16.5 - Enterprise loans1.2 2.52.9 - Household loans8.81.02.63.6 Charges as % of loans1.9%0.4%0.8%1.1% Charges as % of loans1.2%0.2%0.5%0.6% Net interest income22.019.915.914.8 Net earnings9.914.28.45.9 Recapitalisation needs – amount of capital injection needed to keep all banks above 8% CAR n/a0.10.250.5 45 commercial banks analysed

46. 46 Stress tests December 2010 Results Distribution of commercial banks assets by capital adequacy ratio Data for 45 commercial banks was analyzed Banks which need recapitalization

47. 47 Financial stability – general remarks Macroprudential analysis and the role of central banks How to conduct macroprudential analysis ? Stress-testing – types of stress tests and methods How to use the results ? The European context – the ESRB Agenda

48. 48 How to use the results of the analysis? Let us come back to the main objective of macroprudential policy - prevention and mitigation of systemic risk: (1) analysis of the financial system (2) early identification of risks (3) remedial action Given proper identification of risks how can we mitigate them?

49. 49 How to use the results of the analysis? What so far has proved inefficient in safeguarding financial stability? –Central banks had in many cases proper information and analysis on potential systemic risks but also very limited set of tools for conducting macroprudential policy –Supervision authorities had wider set of tools but limited information on the sources of systemic risks and focus on microprudential aspect A need of establishing one body provided with responsibility/mandate for macroprudential policy and adequate powers Better coordination of various policies - use of microprudential instruments for macroprudential purposes needed Need for cross-border coordination –Particularly vital for emerging economies with high share of foreign capital in the financial sector

50. 50 How to use the results of the analysis? Macro objective, but both macro & (mainly) micro tools Macroprudential objective Macro tools e.g. -counter cyclical buffers Micro tools e.g. -supervisory regulations -supervisory recommendations Moral suasion

51. 51 Financial stability – general remarks Macroprudential analysis and the role of central banks How to conduct macroprudential analysis ? Stress-testing – types of stress tests and methods How to use the results ? The European context – the ESRB Agenda

52. 52 Tasks of the ESRB Definition and gathering of all the relevant information for the assessment of systemic risks in the EU, including on financial institutions, markets and infrastructures Identification and prioritisation of systemic risks in the EU Issuance of risk warnings when systemic risks are significant Issuance of recommendations to contain the identified risks Monitoring of the follow-up to warnings and recommendations International coordination with the IMF, FSB, and third parties

53. 53 Structure of the ESRB SECRETARIAT (Staffed by employees of the European Central Bank) Analytical, statistical, administrative and logistical support to ESRB GENERAL BOARD Main decision-making body Voting members include: President and Vice-President of the ECB Governors of EU national central banks Member of European Commission 3 Chairpersons of the European Supervisory Authorities (for banking, securities & markets, insurance) ADVISORY SCIENTIFIC COMMITTEE 15 external experts (academics, representatives of SMEs or trade-unions, providers or consumers of financial services) with a wide range of skills and experiences STEERING COMMITTEE Prepares meetings of the General Board Reviews documents to be discussed Monitors progress of the ESRB’s ongoing work ADVISORY TECHNICAL COMMITTEE Representatives of national central banks, national supervisory authorities, European Supervisory Authorities

54. 54 ESRB warnings and recommendations 1) Aimed at containing significant systemic risks, as identified by the ESRB 2) Can be be addressed to the EU as a whole, individual countries, European Supervisory Authorities or national supervisors (not individual financial institutions) 3) Recommendations include a specified timeline for policy response 4) The addressees of recommendations should report to the ESRB their actions or justify any inaction; the ESRB can decide that recommendations have not been complied with or that the justification for inaction is not appropriate 5) The ESRB can decide to publish its recommendations on a case-by-case basis, as a tool to foster compliance

55. 55 Thank you for your attention!