Identifying Vulnerabilities

The first stage in the stress-testing process is the identification of the main vulnerabilities. Narrowing the focus of the exercise permits a more refined analysis, because it is unrealis­tic to attempt to stress every possible risk factor for a portfolio or system. Focusing on the weak points in a financial system enables the assessor to tailor the stress-testing exercise more effectively and thus permits a richer understanding of inherent vulnerabilities and a more effective use of time and resources.

Isolating the key vulnerabilities to stress test is an iterative process that involves both qualitative and quantitative elements. System-focused stress tests can use a range of numerical indicators to help isolate potential weaknesses, including the “big picture” or macrolevel indicators, broad structural indicators, and institution-focused or microlevel indicators. Those measures should be seen as providing complementary information on potential vulnerabilities. This process may be facilitated by drawing on a range of exper­tise in the context of a dedicated working group.

Knowledge of the broader macroeconomic environment will provide an overall context for the performance of the financial system and will indicate potential sources of shocks. Understanding the macroeconomic picture aids the understanding of what is “normal” for an economy with respect to its own history and in comparison with other countries. This information provides a useful metric for understanding potential sources of shocks, because key macrovariables and financial variables that are the most volatile, misaligned, or out of equilibrium are often the most susceptible to major shocks or realignments. This analysis can also inform the macrosimulations described later. Such an analysis can use data about the real sector, the government sector, and the external sector and can draw on the existing sources of macroeconomic analysis from local or external sources, including IMF Article IV consultation reports.

A variety of indicators of the structure of the financial system can provide important insights into the location of risks in the financial system, including data on ownership and market shares, balance-sheet structures, and flow-of-fund accounts. Qualitative informa­tion on the institutional and regulatory frameworks that govern financial activities can also help to interpret developments in a range of indicators. Discussions with supervisors and regulators, private sector analysts, and market participants can be quite revealing as to the likely sources of vulnerability in a financial system. This type of information is often anecdotal in nature, which may make interpretation difficult, but it can provide important context to an assessment of potential financial sector vulnerabilities and can form the starting point for more quantitative assessments of vulnerabilities.

In addition to using the broad macroeconomic context and structural indicators, we can use a range of FSIs to narrow the focus and to understand the financial system’s vul­nerability to shocks and its capacity to absorb the resulting losses. The analysis of FSIs can be informed by the information gathered from the macroeconomic and structural indicators discussed earlier.

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