Thursday, January 5, 2012

Macroprudential stress testing of credit risk : a practical approach for policy makers

Drawing on the lessons from the global financial crisis and especially from its impact on the banking systems of Eastern Europe, the paper proposes a new practical approach to macroprudential stress testing. The proposed approach incorporates: (i) macroeconomic stress scenarios generated from both a country specific statistical model and historical cross-country crises experience; (ii) indirect credit risk due to foreign currency exposures of unhedged borrowers; (iii) varying underwriting practices across banks and their asset classes based on their relative aggressiveness of lending; (iv) higher correlations between the probability of default and the loss given default during stress periods; (v) a negative effect of lending concentration and residual loan maturity on unexpected losses; and (vi) the use of an economic risk weighted capital adequacy ratio as the relevant outcome indicator to measure the resilience of banks to materializing credit risk. The authors apply the proposed approach to a set of Eastern European banks and discuss the results.

The financial crisis has revealed the need for better macroprudential oversight and a more appropriate and timely policy response. Regular stress testing of the financial system is the main tool of macroprudential monitoring. Despite the widely recognized importance of conducting stress tests, there appears to be a consensus among macroprudential practitioners that stress tests were not informative enough and did not enforce an adequate policy response prior to the global financial crisis (Galati and Moessner, 2011; Haldane, 2009; Turner, 2009; de Larosiere, 2009; Cihak, 2007; Sorge, 2004). This partial failure of stress tests has lead to the development of a new generation of stress testing models (Foglia, 2009; Breuer et al., 2009; Swinburne, 2007).

Our proposed methodology described in detail in this paper improves on the existing stress tests by integrating into one coherent framework the following attributes:

An explicit and robust link of systemic credit risk to macroeconomic conditions based on cross-country experience that can be further tailored to country specific conditions, and that allows for the credit risk sensitivity to changing macroeconomic conditions to increase during crisis times.

A bank-specific, idiosyncratic component of credit risk based on the different underwriting standards across individual banks and their aggressiveness in lending, including the assumption of indirect credit risk from foreign currency lending to unhedged borrowers.

The correlation between the probability of default and the loss given default is allowed to increase in times of stress following Moody’s (2010).

A bank’s lending concentration within individual asset classes and the extent of the performed maturity transformation are allowed to play an important role in bank specific capital charge calculations, eliminating some of the drawbacks of the capital charge calculation based on Basel II methodology.

The attributes are prudently combined to produce a more relevant outcome indicator measuring bank resilience to macroeconomic as well as bank specific shocks.

In a nutshell, while retaining tractability, the methodology attempts to improve on existing approaches by linking the financial sector explicitly to the macroeconomy and accounting for both systemic risk factors due to changing macroeconomic conditions as well as for idiosyncratic risk factors due to the diverse lending practices and risk profiles of individual banks. It was developed to provide policy makers and practitioners with an integrated, flexible and policy relevant tool that can be readily implemented.

The paper starts with a broad motivation on the need to develop a new methodology for macroprudential stress tests concerning Eastern European countries. It proceeds with a presentation of the overall concept of the proposed new methodology. This concept outline is followed by a detail description of the methodology in a manner equivalent to a user-manual with references to supporting sources and literature. An empirical application of the methodology is then presented using data on a set of Eastern European banks, and followed by example policy recommendations based on the acquired stress test results.

World Bank.Author: Buncic, Daniel ; Melecky, Martin. Document Date: 2012/01/01.Document Type: Policy Research Working Paper.Report Number: WPS5936

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