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Case Study on Stress testing the banking system and
Financial Stability Report writing in Azaland
I. Background
1.1 Azaland
Azaland is a small emerging economy that has for many years been one of the fastest-growing
economies. Part of the reason that the crisis has had such a noticeable impact on the country’s banks is
that Azaland is a small open economy that is highly dependent on the economic health of its main
trading partners. Its main trading partners are a number of advanced economies, and Azaland’s exports to
them had grown rapidly over the previous 12 years, the period of rapid growth in the domestic economy.
The rapid economic growth led to rapid credit growth and overheating of the economy over the past
six years. Recently there has been an onset of the global financial and economic crisis, which led to a
fall in external demand, a decline in Azaland’s exports and sharp falls in industrial production and
employment.
1.2 The Exchange Rate Regime
The official currency of the country is the Azaland Shilling (AS). The value of the AS is allowed to float
against other currencies. However, Azaland’s central bank intervenes from time to time to
limit fluctuations in the value of the AS against major currencies. In particular, the
central bank has tended to resist appreciation of the AS arising from capital inflows. The
foreign exchange obtained by the central bank has been mainly been used to limit the
increase in Azaland’s foreign d ebt.
1.3 The Banking Sector
The financial sector is dominated by banks, and its three largest banks make up 95 percent of the
market. Although these three banks have balance sheets of roughly equal size1, they have different
specializations. Ambro bank specializes in corporate landing while BancFirst has an equal focus on
corporate and retail lending. The third, Community bank specializes in retail lending. These banks have
been severely affected by the recent global financial and economic crisis that began i n 2011.
1.4 Monetary Policy and Imbalances
Imbalances in the Azaland economy began to emerge prior to the onset of the recent global financial and
economic crisis. Rapid credit growth and overheating in the domestic economy over the last six years
led Azaland’s central bank to begin tightening monetary policy four years ago. The hope was that by
raising interest rates gradually, inflation would be kept under control and the Azaland economy would
experience a “soft landing”. Unfortunately, however, higher domestic interest rates encouraged
households to borrow in foreign currencies, mainly the US dollar. The attraction for this type of loans is
that they carried lower interest rates. Households apparently have not hedged the foreign exchange risk
associated with these loans, probably because the Azaland exchange rate has been relatively stable for
almost a decade. The growth in foreign currency lending has been linked mainly to purchases of houses,
and some market observers believe that the residential property market is currently in a “bubble”.
1.5 Fiscal Policy and Political Instability
The rapid economic growth experienced by Azaland over the last 12 years had led households and
investors to have confidence in the economy, even against the backdrop of some political instability in the
country. As a consequence of a number of “populist” government initiatives, the public debt has almost
tripled during the last six years reaching the current level of 60 percent of GDP and the country was
1 For
the purposes of the case study, it is assumed that the total balance sheet size of the three banks is identical. The size of loans,
investment portfolio, open foreign exchange position, investment portfolio, off-balance sheet items, interest rate exposure is also
identical. Only the composition of the credit portfolio is different in the three banks. The objective is to study the impact of the
changes in macroeconomic variables on the overall capital adequacy levels arising on account of just one variable – different credit
portfolio composition. It must be noted that this is an oversimplification and the real life situation would be more complex.
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recently downgraded by a major credit rating agency. The fiscal deficit has grown to 6 percent of GDP
in 2012 and has been associated with a higher risk premium on government bonds. More recently,
after the last election and the onset of the financial and economic crisis, the government has started
to seriously address its fiscal problems. It has consulted with the central bank and has agreed on the
necessary steps for fiscal stabilization. However, these efforts are being complicated by the fall in
external demand associated with the crisis leading to sharp decline in government tax revenues.
II. The Azaland economy
In addition to the macroeconomic effects discussed above, the global financial and economic crisis has
had additional affects at the sectoral level. The impact of the crisis on the corporate, household and
banking sectors, in addition to information on their structure, is described below.
2.1 The corporate sector
Non-financial firms in Azaland have been transformed during the last 15 years into globally competitive
companies with most of their revenues obtained from r e s o u r c e exports. Almost 70 percent of
Azaland’s domestically produced output is exported to the three advanced economies. These companies
have mainly focused on the production of minerals, oil and gas products associated with the “natural
resource base”. An increase in production efficiency coupled with the surge in world demand for
commodities has led over the last 10 years to greater profits, which have mostly been invested back into
new production technologies. Domestic firms have increased their production capacity greatly, built up
new branches and even invested abroad. At the same time, a number of domestic firms have focused
instead on the property market. About 15 percent of Azaland’s non- financial companies are involved in
the property market business. Firms have been attracted to real estate and development businesses
because of rising real estate prices. Much of this investment has been financed by foreign exchange
loans obtained at low interest rates.
The global financial and economic crisis strongly impacted Azaland’s corporate sector. Firms in the real
estate business were hit at first as the domestic demand for housing and commercial properties fell.
Many such firms had serious difficulties in meeting their debt obligations. Banks have tended to tighten
credit standards in response.
The sharp decrease in domestic and external demand has meant that corporate needed to reduce their
costs significantly. Their overseas expansion and investments has led to a tight liquidity p o s i t i o n .
Consequently, some of these firms have had serious problems with their debt service. The liquidity
strains have been further exacerbated by the tightening of credit standards by commercial banks.
External financing has also become more difficult to obtain at reasonable rates because of an increase in
perceived country risk.
Most analysts assume that the situation in the corporate sector will deteriorate further in 2013; however,
there is disagreement concerning the depth of the recession and longer-term outlook. This disagreement
is related to the uncertainty associated with potential government actions and also the strength of the
global economic recovery. Some forecasts suggest that a very modest recovery will take place in 2014
with default rates in the corporate sector peaking in the end of 2013.
2.2 The household sector
The Azaland economy had grown steadily over the 12 years preceding the crisis. During this period, the
profits of the corporate sector and real wages both rose steadily, leading to a higher standard of living
for the country’s 10 million inhabitants. Expectations of continued economic prosperity in Azaland fuelled
rising indebtedness of households and a drawing- down of their financial safety buffers. Due to lower
foreign interest rates, much of this borrowing was in foreign currencies, mainly the US dollar. Although
the lower cost of foreign borrowing tended to reduce households’ debt burden, rising house prices meant
that first-time home buyers needed to borrow more heavily.
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Prior to the crisis, households were easily able to meet their financial obligations; however, the situation
changed in 2012 with the number of household insolvencies increasing. Analysts assume that this number
will double by the end of 2013 and triple by the end of 2014. They further expect that the heightened rate
of household insolvencies will be more persistent then the rise in the corporate default rate, in part
because of the obvious currency mismatch between households’ incomes and expenses and a likely
further depreciation in the value of the AS.
2.3 The government sector
Azaland’s government is expected to coordinate with the central bank to deliver a policy package to deal
with the crisis. An assumption underlying this package is that the fiscal deficit will fall to just 3 percent
of GDP within four years (i.e. by the end of 2016).
2.4 The banking sector
Azaland’s banking sector provides various services to individual and corporate clients, and most of the
sector’s revenues are derived from lending. Because the role of securities markets in firms’ funding is
still very limited, most domestically based corporations obtain their external financing entirely from
banks. Other important business lines include commercial real estate and residential mortgage lending,
small business banking, consumer banking, investment banking and private banking.
The banking sector has been profitable recently with an ROE of more than 10 percent over the last five
years and an ROA of about 3 percent. Banks are well capitalised with proper risk management,
and the three largest banks have adopted the Basel II IRB framework for determining regulatory capital
requirements for credit risk in the banking book. However, due to the global financial and economic crisis
and foreign exchange loans to households, significant losses are expected in the banking industry.
III. Macro stress testing
The recent financial and economic crisis has caused a fall in confidence in the Azaland banking sector.
Some economists expect that banks will suffer large losses next year. Although commercial banks have
publicly announced that they will remain solvent, even if the situation deteriorates further, there is
nevertheless much uncertainty about the resilience of the country’s banking sector. To assess the
robustness of the Azaland banking sector, the central bank decided to implement a macro stress test.
3.1 Stress testing methodology
The aim of stress tests is to evaluate financial sector resilience to adverse macroeconomic shocks and to
expose weaknesses of the financial system as a whole. These assumed adverse macroeconomic shocks
comprise the stress test scenario. Such a scenario is usually severe; however, it should also be plausible.
In emerging economies such as Azaland, macro stress testing is primarily concerned with assessing
the systemic risk of the banking sector. Often the capital adequacy ratio is used to determine whether
current bank capital is sufficient to permit a particular bank to survive adverse macroeconomic shocks.
Plausible stress tests should take into consideration transmission channels in the economy, and to the
extent possible any self-reinforcing feedback loops that might develop. The impacts on banks’ balance
sheets are calculated and the results are aggregated for the whole sector. It is expected that banks
will tighten lending standards in response to large unexpected credit losses. This can lead to a further
deterioration in the macroeconomic environment. Although this can generate a self-reinforcing feedback
loop, the Central Bank of Azaland currently does not have a formal methodology to take this into
consideration.
There are basically two approaches for macro stress testing – bottom up and top down. The bottom-up
approach is based on the aggregated results of the individual banks’ stress tests which are conducted by
the banks themselves using different assumptions depending on particular bank business models.
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However, all the banks use the same macro scenarios produced by the regulator, who also exercises
some control over the plausibility of the banks’ assumptions and models. The top-down approach,
in contrast, is completely designed and performed by the regulator; the same assumptions are applied
to all banks’ balance sheet data and different business models are not taken into account. The Azaland
central bank decided to follow a top-down approach.
3.2 Macro scenarios
There are two widely used approaches to forming scenarios that underpin stress tests. One approach,
known as sensitivity analysis, assesses the impact on a country’s financial system of a shock to one
variable, such as the level of interest rates or the country’s exchange rate. Another approach, and the one
used by most central banks, is scenario analysis, which examines the impact of changes in a number of
key variables. Scenario analysis has the advantage of being a more plausible approach to stress
testing, because in a crisis more than one key variable would be expected to change in an important
way. The most common macroeconomic variables shocked in the scenarios are GDP, interest rates, the
exchange rate, inflation, the unemployment rate and real estate prices. A central bank’s official
macroeconomic forecast usually serves as a starting point for macro scenarios. Between two and four
worst case scenarios, relative to the baseline forecast, are commonly used for each round of stress
testing. The scenarios are generated using macroeconomic modeling, which is performed in a similar
way to that for monetary policy purposes. However, these techniques are usually problematic under
adverse scenarios as they tend to underestimate the magnitude of the responses of key variables to
large shocks. Apart from standard demand and supply shocks in the economy, there can also be other
shocks related to changes in consumer behaviour, changes in legislation, etc. These situations are not
usually covered by conventional stress test exercises.
In line with common practice, Azaland’s central bank decided to shock GDP, three-month interest
rates, the unemployment rate, the nominal exchange rate and a real property price index covering
commercial as well as residential real estate markets in the scenarios studied. A baseline scenario,
obtained from a macroeconomic forecast, served as the starting point to design one adverse scenario.
The following tables present the baseline and adverse scenario developed by the Azaland central bank.
Table 1: Baseline scenario
Variable
Real GDP growth rate
Interest rate (three-month interbank rate)
Unemployment rate
Nominal exchange rate index (increase =depreciation
Real estate price index2
Actual
2012
3.00%
5.00%
5.00%
100
100
Projection
2013
-3.00%
3.00%
7.00%
120
80
Projection
2014
0.00%
1.00%
8.00%
115
85
Actual
2012
3.00%
5.00%
5.00%
100
100
Projection
2013
-3.00%
2.00%
10.00%
135
70
Projection
2014
-3.00%
0.00%
13.00%
130
75
Table 2: Adverse scenario
Variable
Real GDP growth rate
Interest rate (three-month interbank rate)
Unemployment rate
Nominal exchange rate index (increase =depreciation)
Real estate price index
2
Real estate price index covers commercial and residential housing markets
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3.3 Stress test assumptions
Macro stress tests rely on many assumptions and a number of simplifications. One key assumption is the
appropriate time horizon of the exercise. A longer horizon can lead to better insight into potential
future effects, but it is also likely to be associated with greater uncertainty about these effects. A
common practice is an assumed time horizon of one or two years. However, some central banks also
design stress tests with three-year time horizons. The Azaland central bank decided to go with a oneyear horizon due to the extremely high uncertainty related to future economic developments.
The most common risks which are usually covered are credit risk, interest rate risk and exchange rate risk.
Regulators also at times try to measure the solvency risk arising from interbank exposures, sometimes
referred to as interbank contagion risk, and liquidity risk. Based on its data sources, the Azaland central
bank was able to stress-test for credit risk, interest rate risk, exchange rate risk and interbank contagion
risk.
There are of course other important risks which are not covered by these tests, but the central bank
considered the tests implemented as important steps to evaluate the systemic risk of the Azaland
banking sector. It is hoped that these exercises will give important information to the regulator, helping it
to decide which measures, if any, need to be taken.
Macroeconomic shocks are projected to individual bank balance sheets. In order to capture the
transmission channel, much simplification is needed. Some portfolio segmentation has to be made to
calculate credit risk for these segments.
Regulators with more elaborate methodology split the credit portfolio into retail and corporate books and
further into investment loans, commercial real estate loans, residential housing loans, consumer loans,
etc. Based on data availability, the Azaland central bank decided to split the portfolio into corporate,
retail and other loans. The details of the credit portfolio of the banks are furnished in Table 3.
Table 3: Portfolio composition before the shocks
Corporate
Households
Other
Share of total loans of the banking sector
Total loans
Total
Share of Total Loans
Ambro
BancFirst
40%
40%
20%
100%
207,756,658
75%
5%
20%
33%
69,252,286
40%
40%
20%
33%
69,252,286
Community
Bank
5%
75%
20%
33%
69,252,286
The probability of default (PD) projection for the corporate borrowers, i.e. the corporate portfolio, is
linked to GDP (it is assumed that 1 percent change in GDP leads to a change in PD by 80 percent).
The PD for the retail portfolio was linked to unemployment. The PD for other loans was linked to the
corporate PD projection. Estimated losses given default (LGDs) were linked to the real estate price index
as shown in Tables 4a and 4b below.
Table 4 a: Average elasticities for PD estimation
Corporate PD-GDP
Retail PD – Unemployment
Other PD - GDP
80%
120%
100%
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Table 4 b: Average elasticities for LGD estimation
Corporate LGD – Real estate Price Index
Retail LGD – Real estate Price Index
Other LGD – Real estate Price Index
50%
100%
70%
Based on the above assumptions, the Central Bank calculates historical and estimated portfolio default
rates PDs and portfolio loss rates ( LGDs) as given in Tables 5a and 5b below.
Table 5a – Baseline Scenario
Credit risk
Corporate
Retail
Other
Historical
PD
2012
1.20%
1.00%
0.20%
Expected one – year PD
2013
6.00%
3.40%
1.00%
Historical
LGD
45%
45%
45%
Corporate
Retail
Other
2014
3.60%
4.60%
0.60%
Expected LGD
55%
65%
59%
Table 5b – Adverse Scenario
Credit risk
Corporate
Retail
Other
Historical
PD
2012
1.20%
1.00%
0.20%
Expected one – year PD
2013
6.00%
7.00%
1.00%
Historical
LGD
45%
45%
45%
Corporate
Retail
Other
2014
6.00%
10.60%
1.60%
Expected LGD
60%
75%
66%
3.4. Risk assessment
3.4.1Credit risk
Credit risk is the most important risk on banks’ balance sheets. The Central Bank of Azaland currently
does not have a model for estimating the projected balance sheet of the banking system over one or two
years. It has decided to keep this estimation exercise relatively simple by deciding to make projections
for only loans on the asset side of the balance sheet. Other assets are assumed to be constant. Table 6
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provides the results of the credit growth projections for the three banks under the baseline scenario.
Table 6: Expected credit growth
Annual year - on - year growth
Historical
6.00%
8.00%
5.00%
Corporate
Retail
Other
Expected
-6.00%
-1.00%
-4.00%
In order to assess the quality of banks’ credit portfolio, the Central Bank also makes projections relating
to the level of non-performing loans. The projections under the baseline and adverse scenarios are given
in Table 7a and Table 7b. The Central Bank also estimates credit risk parameters 3 (PD and LGD) as
described in the earlier section.
Table 7a-Baseline Scenario
Ambro Bank
2012
BancFirst
2013
2012
Community Bank
2013
Baseline
2012
2013
Baseline
Baseline
Gross non performing loans
342,874
3,595,900
342,874
2,968,825
342,874
2,341,749
Corporate
257,156
3,280,932
137,150
1,749,831
17,144
218,729
Households
17,144
129,147
137,150
1,033,173
257,156
1,937,199
Other
68,575
185,821
68,575
185,821
68,575
185,821
NPL ratio
0.50%
5.49%
0.50%
4.45%
0.50%
3.45%
Corporate
0.50%
6.72%
0.50%
6.72%
0.50%
6.72%
Households
0.50%
3.77%
0.50%
3.77%
0.50%
3.77%
Other
0.50%
1.40%
0.50%
1.40%
0.50%
1.40%
Performing loans
68,909,412
61,951,389
68,909,412
63,790,379
68,909,412
65,629,370
Corporate
51,682,059
45,541,929
27,563,765
24,289,029
3,445,471
3,036,129
3,445,471
3,298,842
27,563,763
26,390,733
51,682,059
49,482,623
13,781,882
13,110,618
13,781,882
13,110,618
13,781,882
13,110,613
Households
Other
3
Credit risk is typically the most important risk on banks’ balance sheets. As such it is critically important for the stress test
exercise to assess correctly how credit risk is likely to evolve in response to adverse macroeconomic developments. In order to
estimate future PDs consistent with a given macro scenario, macro credit risk models are usually employed. These models
attempt to link future expected default rates to macroeconomic developments. As a default rate predictor, macroeconomic
variables such as GDP, interest rates, the exchange rate or wage growth could be considered. However, non-linearity could make
modeling more difficult.
The lack of adequate data such as short time series and structural breaks are often encountered when assessing the parameters
for credit risk. In such situations, expert judgment may be used to arrive at the estimates. In general, PDs can be linked to a single
macroeconomic variable. Expected losses can then be calculated as a product of exposure at default (EAD), expected average PD
for the considered portfolio, and loss given default (LGD). Determining appropriate LGDs remains a rather big challenge and
regulators usually do not have macroeconomic models to produce LGDs as they do for PDs. For this reason, the LGD parameter is
very often determined mainly by expert judgment. Property price developments can often be used to inform on appropriate
values for LGSs, because a significant part of loan portfolios could be secured
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TABLE 7b – Adverse Scenario
Credit Risk: Projected NPLs and Performing Loans
Ambro Bank
2012
BancFirst
2013
2012
2013
Adverse
Gross non-performing loans (NPL)
Corporate
Households
Other
NPL ratio
Corporate
Households
Other
Performing loans
Corporate
Households
Other
Community Bank
2012
2013
Adverse
Adverse
342,874
257,156
17,144
68,575
3,719,937
3,280,932
253,184
185,821
342,874
137,150
137,150
68,575
3,961,120
1,749,831
2,025,468
185,821
342,874
17,144
257,156
68,575
4,202,303
218,729
3,797,753
185,821
0.50%
0.50%
0.50%
0.50%
5.68%
6.72%
7.39%
1.40%
0.50%
0.50%
0.50%
0.50%
5.93%
6.72%
7.39%
1.40%
0.50%
0.50%
0.50%
0.50%
6.18%
6.72%
7.39%
1.40%
68,909,412
51,682,059
3,445,471
13,781,882
61,827,352
45,541,929
3,174,805
13,110,618
68,909,412
27,563,765
27,563,765
13,781,882
62,798,084
24,289,029
25,398,437
13,110,618
68,909,412
3,445,471
51,682,059
13,781,882
63,768,816
3,036,129
47,622,069
13,110,618
3.4.2 Foreign exchange risk
A currency mismatch on banks’ balance sheets can materialize into losses. Hence foreign exchange risk is
an important part of the financial sector assessment. There can be f o r e i g n e x c h a n g e risk
on banks’ balance sheets as well as in off-balance sheet exposures. To assess any currency mismatch we
need to calculate the net open foreign exchange position for all currencies and multiply them by
expected exchange rate changes.
Azaland’s central bank includes in the stress test foreign exchange risk for on- as well as off-balance
sheet net foreign exchange open positions. It uses only the AS/USD exchange rate, as 95 percent of the
aggregated banking foreign exchange loans are denominated in US dollars. Apart from the currency
mismatch of the banking sector, foreign exchange risk can also contribute significantly to
vulnerabilities of the other economic sectors. Non-financial export-oriented firms suffer from the
appreciation of the domestic currency as their products become more expensive on foreign markets.
However, for importers, the opposite statement is true. To deal with the foreign exchange shock,
companies have to adjust their production, hedge against foreign exchange change or try to sell their
product domestically. On the other hand, households with f o r e i g n e x c h a n g e loans usually do
not have any f o r e i g n e x c h a n g e income at all and therefore they can be strongly hit by domestic
currency depreciation. Relative to corporates, they have much less flexibility to adjust their financial flows
to the shock.
Nevertheless, foreign exchange risk on non-financial sector balance sheets is transferred to credit risk
for the banks. This transmission channel is within the stress test usually covered by credit risk models for
the real sector.
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Table 8 below shows the results of the foreign exchange risk calculation for the three analyzed banks
and baseline scenario.
Ambro
4,880,422
BancFirst
4,880,422
Community
4,880,422
Foreign exchange shock ( >0 = depreciation)
20.00%
20.00%
20.00%
Impact of net open foreign exchange position ( <0 = loss)
-976,084
-986,084
-976,084
Total net open foreign exchange position
3.4.3 Interest rate risk
Interest rate risk is one of the most important market risks examined in a stress test exercise. The
risk stems from changes in the value of securities. In order to capture that risk, securities are usually split
into more homogeneous segments using an average duration for the calculation. Changes in the value of
securities can be simply calculated as a product of the interest rate change, duration and original value of
securities. However, this calculation can overestimate the effects of changes in interest rates: some banks
may keep their securities on balance sheet until maturity and thus are not exposed to changes in
the interest rate as they do not intend to sell them.
Another difficulty with the interest risk evaluation is related to hedging. Banks usually try to mitigate
their risks using hedging instruments such as interest rate swaps that also can make a significant
difference in the final impact of the shock on banks’ balance sheets. Nevertheless, this information is
usually not available and it is hard for regulators to deal properly with these obstacles. For this reason,
simplifications based on the experience with the particular banking sector are typically undertaken.
The Azaland central bank calculates the risk for government securities, municipal securities and other
securities. Apart from on-balance sheet positions it also calculated interest rate risk related to offbalance sheet positions. In this case only the total off-balance sheet volume is considered and it is
not split further into segments. As the Azaland central bank does not have appropriate data on
hedging, this feature is not implemented within the exercise.
Table 9 provides the results of the interest risk calculation for the three analyzed banks and baseline
scenario.
Table 9 Interest rate risk
Ambro
BancFirst
Community
Change in values
On-balance sheet
Government securities
Municipal securities
Foreign debt securities
All other securities
Off-balance sheet
444,446
2,066
216
8,696
660,104
444,446
2,066
216
8,696
660,104
444,446
2,066
216
8,696
660,104
Total change in values
455,424
455,424
455,424
3.4.4 Income and capital modeling
Income modeling is one of the most important, challenging and tricky issues. The net income
generated by banks is the first line of defense against declining capital. From this point of view,
income modeling is the crucial part of each stress test exercise. However, it is very difficult to project
future banking incomes, which depend in unpredictable ways on a large number of factors. In general,
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the net banking income can be calculated as a sum of differences b e t w e e n i n t e r e s t i n c o m e s
a n d e x p e n s e s , a n d n o n -interest i n c o m e s a n d expenses. The impact of the macroeconomic
shocks to net interest income is usually better captured as there is a high correlation with interest rate
changes and economic cycle. However, changes in net non-interest income are hard to predict as it
depends importantly on the banks’ business models as well as on banks’ response to the new
macroeconomic situation.
The Azaland central bank does not have any estimation on the banking sector income projections. Hence
it used average net income over the last three years (2010–12) as a proxy. However, to capture the effect
of changes in interest rates, net interest rates, net interest income is multiplied by the change in
interest rates.
The Central Bank has assumed that there will be no dividend payments as the three banks have made
public announcements that they will not payout any dividend over the next two years due to the
financial crisis.
The Central Bank of Azaland assesses the resilience of the banking sector by estimating changes in
Capital adequacy ratios after shocks applied under the stress test. Tables 10a and 10b show the income
and capital projections for the three banks under baseline and adverse scenario.
TABLE 10a: Income & Capital Modeling – Baseline Scenario
Ambro
1
2
3
4
Income
Average (for years 2010,2011 & 2012) net nonInterest income
Average net interest income
IR change
Impact of IR change on net interest income
5
Total net expected income after shock (1+2+4)
6
7
8
9
Total impact of credit risk, interest rate risk and
Exchange rate risk shock (7+8+9)
Of which, credit risk
Interest rate risk
Exchange rate risk
10
11
12
13
14
15
Total net expected income after all shock (5+6)
Capital
Initial capital CAR (%)
Initial capital before the shock
Capital after shock (10+12)
RWA after shock
Capital (%) CAR after shock
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BancFirst
Community
-222,401
564,210
-2.00%
-11,284
-222,401
564,210
-2.00%
-11,284
-222,401
564,210
-2.00%
-11,284
330,525
330,525
330,525
-1,567,437
-1,046,777
455,424
-976,084
-1,837,077
-1,316,417
455,424
-976,084
-2,106,717
-1,586,057
455,424
-976,084
-1,236,912
-1,506,552
-1,776,193
11.13%
11,028,192
9,791,280
108,192,793
9.05%
11.13%
11,028,192
9,521,640
90,614,626
10.51%
11.13%
11,028,192
9,251,999
90,859,716
10.18%
Table 10b: Income & Capital Modeling – Adverse Scenario
Ambro
BancFirst
Community
1
2
3
4
Income
Average (for years 2010,2011 & 2012) net nonInterest income
Average net interest income
IR change
Impact of IR change on net interest income
-222,401
564,210
-3.00%
-16,926
-222,401
564,210
-3.00%
-16,926
-222,401
564,210
-3.00%
-16,926
5
Total net expected income after shock (1+2+4)
324,883
324,883
324,883
6
7
8
9
Total impact of credit risk, interest rate risk and
Exchange rate risk shock (7+8+9)
Of which, credit risk
Interest rate risk
Exchange rate risk
-3,003,448
-1,978,436
683,136
-1,708,148
-4,005,122
-2,980,111
683,136
-1,708,148
-5,006,796
-3,981,785
683,136
-1,708,148
-2,678,565
-3,680,239
-4,681,914
11.13%
11,028,192
8,349,627
137,965,038
6.05%
11.13%
11,028,192
7,347,953
116,785,214
6.29%
11.13%
11,028,192
6,346,278
98,740,877
6.43%
10
11
12
13
14
15
Total net expected income after all shock (5+6)
Capital
Initial capital CAR (%)
Initial capital before the shock
Capital after shock (10+12)
RWA after shock
Capital (%) CAR after shock
5. Overall impact of the stress test on Azaland banking system
The overall impact of the stress test on the capital ratios of the three banks in Azaland is given in Table 11
below.
Table 11 Capital Ratios after stress test
Initial capital before the shock
Baseline scenario – after shock capital
Adverse scenario – after shock capital
Total
11.13%
9.86%
6.24%
Ambro
11.13%
9.05%
6.05%
BancFirst
11.13%
10.51%
6.29%
Community
11.13%
10.18%
6.43%
6. Bank management response to stress test results
Although the three major banks seem to be able to cope with the financial and economic crisis under
the baseline scenario, capital adequacy ratios would deteriorate markedly under the adverse scenario.
C o m m u n i t y i s t he most vulnerable bank, i t specialises in retail lending - apparently strongly
hit by the crisis due to credit as well as foreign exchange risks. BancFirst would also fall below the 8
percent level under the adverse scenario. Both of these banks decide to reduce their lending to
households and focus more on corporate business.
All three banks are planning to improve their risk management, cutting back on retail lending and
tightening foreign exchan ge credits to households.
7. System-level perspective
The Azaland central bank considers the performed stress test exercise based on the top- down
approach as a first step to identify systemic risks in the domestic banking sector. The regulator plans
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further improvements in this framework and closer cooperation with the banks. It would also like
to conduct the stress test exercise based on the bottom-up approach for better calibration of some
key parameters used in the exercise.
The central bank also monitors risk in the household sector and assesses the new business strategy of the
commercial banks as a response to the stress test exercise. All three banks trying to increase their market
share in corporate lending significantly at the same time will pose challenges on profit margins and
henceforth potential future risks. The regulator specifically worries about the weaknesses of Community
bank, which will face funding liquidity problems due to the anticipated reduction of the other banks’
exposure to it. Despite the fact that information about the results for the individual banks was not
publicly disclosed (the results were only provided to the three banks), the central bank is afraid that
leaking this information might trigger a run on Community bank. As mitigate, the regulator announced
special liquidity swap lines for the domestic banking sector to increase market confidence in the sector.
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GROUP TASKS FOR THE MACROSTRESS TESTING AND FORWARD LOOKING
FINANCIAL STABILITY REPORT OF THE CENTRAL BANK OF AZALAND
Groups A, B, C
1. What are the main threats to financial stability in Azaland?
2. Which macroprudential (economic and financial) indicators should the Central Bank of Azaland consider
for its financial stability assessment and for identifying the vulnerabilities to the financial system?
Group A
3. How do you assess the overall design of the
stress testing framework of the Central Bank of
Azaland? You may like to analyze the advantages and disadvantages, in particular, of the following:




appropriateness of the time horizon,
top-down versus bottom up approach,
P r o j e c t i o n s o f credit risk parameters – (PD and LGD),
Assessment of other risks
Group B
4. Is the stress test framework of the Central Bank of Azaland comprehensive enough to capture the major
risks of the banking sector? Are you satisfied with the adequacy, integrity, depth and scope of the data
use?
Group C
5. How do you analyze and assess the stress test results under the baseline and adverse scenario for the
banking system in Azaland? What are the issues that you would like to raise in your discussions with the
management of Ambro, BancFirst and Community? You may like to consider the following:
o
o
o
The central bank’s perspective on the system-wide impact
Impact of the stress test on each individual bank
Management response to the stress test findings
Optional question
6. Do you agree that the scenario developed by the Central Bank of Azaland is severe but plausible? How
would you define a severe but plausible stress testing scenario? How should the stress test results be utilized in
supervisory policy?
Groups A, B, C
7. Sketch a proposed outline of a Forward Looking Financial Stability Report for the Central Bank of
Azaland. Indicate the risks that you might emphasize in the stress tests, what might be the transmission
channels. What measures would you propose to deal with these risks.
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