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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. 1/13 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. 2/13 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. 3/13 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 4/13 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% 5/13 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 6/13 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 7/13 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. 8/13 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, 9/13 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 10/13 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 11/13 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. 12/13 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. 13/13