System-Focused Stress Testing

Stress testing, in the context of financial sector surveillance, refers to a range of techniques to help assess the vulnerability of a financial system to exceptional but plausible events.17 It is based on applying a common set of shocks and scenarios to a set of individual finan­cial institutions and subgroups of institutions to analyze both the aggregate effect and the distribution of that effect among the institutions. Stress tests were originally developed for use at the portfolio level so one can understand how the value of a portfolio changes if there are large changes to some of its risk factors (such as asset prices). Those tests have now become widely used as a risk management tool by financial institutions. Gradually, the techniques have been applied in a broader context, with the goal of measuring the sensitivity of a group of institutions (such as commercial banks) or even an entire finan­cial system to common shocks.

System-focused stress testing is best seen as a multi-step process that involves examin­ing the key vulnerabilities in the system and providing a rough estimate of sensitivity of balance sheets to a variety of shocks. This process entails (a) identifying the major risks and exposures in the system and formulating questions about those risks and exposures, (b) defining the coverage and identifying the data that are required and available, (c) calibrating the scenarios or shocks to be applied to the data, (d) selecting and implement­ing the methodology, and (e) interpreting the results. System-focused stress tests attempt to marry a forward-looking macro-perspective with an assessment of the sensitivity of a collection of institutions to major changes in the economic and financial environment.

The process of conducting a system-focused stress test begins first with the identifica­tion of specific vulnerabilities or areas of concern and then with the construction of a scenario in the context of a consistent macroeconomic framework. Isolating key vulner­abilities is an iterative process involving both qualitative and quantitative elements. A range of numerical indicators can be used to help isolate potential weaknesses, including the “big picture” or macro-level indicators, broad structural indicators, and more institu­tion-focused or micro-level indicators. Ideally, a macro-econometric or simulation model

should form the basis of the stress-testing scenarios. A working group of selected experts may facilitate the process.

Once a set of adjustment scenarios has been produced in a consistent macro-frame­work, the next step is to translate the various outputs into the balance sheets and income statements of financial institutions. There are two main approaches to translating macro-scenarios into balance sheets: (a) the “bottom-up” approach in which the effect is estimated using data on an individual institution’s portfolios and (b) the “top-down” approach in which the effect is estimated using aggregated data.

A variety of metrics can be used to summarize the results of stress tests. The most com­mon ones use measures that express the effect of a shock as a percentage of capital, assets, or profitability. For example, the estimated decline in the value of assets (or in equity) or a reduction in net income caused by higher loan loss provisions or by interest rate shock can be expressed as a ratio involving either (a) capital or assets or (b) profitability. The dispersion of the effect (the standard deviation of the effect across the sample of banks) is also a key statistic to monitor. Public dissemination of the results of stress tests may present some difficulties, but the publication of results by a broad range of countries has shown that those difficulties are not insurmountable.

Stress tests are useful because they provide a quantitative measure of the vulnerability of the financial system to different shocks. This measure can be used with other analyses to draw conclusions about the overall stability of a financial system. The value added from system stress tests derives from a consultative process that integrates a forward­looking macroeconomic perspective, a focus on the financial system as a whole, and a uniform approach to the assessment of risk exposures across institutions. Recent trends in Financial Sector Assessment Program (FSAP) stress testing show a shift toward greater integration of a macroeconomic perspective, more involvement by country authorities and individual institutions, and greater coverage of the financial sector.

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