Overview of the “Case Study for Macro Stress Testing and Forward Looking Financial Stability Reports” By Charles Augustine Abuka Director, Financial Stability Department Bank of Uganda COMESA Course on Forward Looking Financial Stability Reports 1 st November 2012 KSMS, Nairobi, Kenya

Outline 1.Macroprudential versus microprudential framework. 2.Financial stability analysis. 3.Macro stress testing : Framework, Macro scenarios, Satellite models, Stress test composition. 4.The case study: Background, macro scenarios and assumptions, Implementation, Tasks for macro stress testing and FSR publication. 2

1. Macroprudential Versus Microprudential Framework Microprudential regulation; It examines the responses of an individual bank to exogenous shocks. It neglects the systemic implications of common behavior. Macroprudential; It identifies and assesses risks and vulnerabilities in the entire financial system. It focuses on systemic risk. 3

2. Financial Stability Analysis Analysis and risk assessment of the economic sectors and external environment. Macroprudential indicators. Macro stress test scenarios. Macro stress testing. Satellite models and composite indicators. Publication of Forward Looking FSR’s: – Recommendations, – policy implications and communication. 4

3. Stress Testing Framework 5

Feedback loop Risks in the economy -Decline in GDP -Depreciation of domestic currency - Increase in interest rates - Decline in housing prices Risks in the economy -Decline in GDP -Depreciation of domestic currency - Increase in interest rates - Decline in housing prices Stress test scenarios from macroeconomic forecast model Risks in individual bank -Credit -Market - Liquidity - Income source - Interbank contagion Risks in individual bank -Credit -Market - Liquidity - Income source - Interbank contagion Impact on bank’s balance sheet Risks in the economy Risks in individual banks 6

3. Stress Testing Framework 7

Top-down Versus Bottom-up Top-down approach; supervisors and/or central banks carry out the impact analysis of different scenarios on banks’ profits, solvency and resilience. Bottom-up approach; with the scenarios provided by the supervisors, each bank estimates their impact on its own profit and loss and solvency ratios using its own internal models; later on results are aggregated. One can justify the reasonable calibration of the top down approach. Cooperation between the regulator and banks is important 8

Sensitivity Versus Scenario Analysis Sensitivity analysis; impact of the change in a variable. Scenario analysis; impact of the change of a set of interrelated variables. 9

Macroeconomic Scenario Official macroeconomic forecast model published by national authorities can be used for the central (baseline) scenario. The derived central scenario serves as a starting point for generating adverse scenarios. Between one and four worst-case scenarios, relative to the baseline forecast, are commonly used for each stress test around. 10

Satellite Models Satellite models can underpin stress test exercises. Forecasting of the key variables employed within the exercise based on the economic scenarios. Examples of satellite models: Credit risk models, Credit growth models, Operating profit modeling. 11

Static Versus Dynamic Stress Tests A dynamic framework is able to better capture effects of macroeconomic shocks on banks’ portfolios. A static stress test is a simple approach to implement, but time inconsistency with macroeconomic forecast and satellite models. Dynamic stress test - every variable used in stress test has time dimensions - inputs as well as outputs. 12

Basic Idea of Stress Testing Macroeconomic shocks are translated into following risks Credit risk, Market risk (e.g. interest rates and exchange rate changes), Interbank contagion. Impacts of shocks are deducted from capital, risk weighted assets are projected - the outcome is capital adequacy ratio. 13

Stress Testing-Possible Solution Credit risk Market risk (IR,FX) Interbank contagion Adverse Macroeconomic Scenarios (external shock, domestic macroeconomic development) Adverse Macroeconomic Scenarios (external shock, domestic macroeconomic development) Credit risk models (increase in NPLs) Credit risk models (increase in NPLs) Credit growth model (change in credit volume) Credit growth model (change in credit volume) Operating profit modeling Banking Sector (individual banking institutions) 14

I NTRODUCTION TO THE AZALAND CASE STUDY 15

Background Hypothetical country – Azaland: Banking sector dominated by the three big banks (95 percent of market share). Small open economy. – Natural resource based. Banking sector - crucial role for financial intermediation. Financial system - heavily influenced by the international financial markets. Significant growth of the economy over the last 12 years. 16

Background The global financial and economic crisis threatens Azaland firms significantly. Negative impact on household disposable income. Rapid credit growth and overheating in the domestic economy over the past six years. Foreign exchange loans to households - currency mismatch on households’ balance sheets. Asset bubble on the property market financed by foreign exchange loans. 15 percent of corporates are currently involved in the real estate business. 17

Background Political instability, populist steps were taken by government in response. Fiscal deficit - currently hit 6 percent of GDP. Government debt reached 60 percent of GDP. The growing budget deficit – exerts a negative impact on government bonds risk premium. 18

Macro scenarios Macro economic scenarios: Baseline, Adverse. Annual data, current year’s values and projections for one year. Macroeconomic variables included in scenarios: GDP, Interest rate (3M interbank rate), Unemployment rate, Nominal exchange rate index (increase=depreciation), Real estate prices index (commercial and resident housing markets). 19

Assumptions One year horizon for stress testing. Credit risk: Credit portfolio was split into-corporate, retail, other, PD and LGD projection based on simple sensitivity approach:  PD-corporate-projection is linked to GDP,  PD-retail-projection is linked to unemployment,  PD-other- relative change is assumed the same as for corporate,  LGD-projection is linked to real estate price index. Credit growth: Projection is linked to GDP, Simple sensitivity approach - corporate, retail and other. 20

Assumptions Basel II formula used for credit risk calculation. Average duration-used for interest rate risk calculation: On balance sheet- securities, Off balance sheet. Foreign exchange risk: Foreign exchange assets and liabilities set up as a share on total. Capital requirement: Increase of capital requirement for market and operational risks is assumed to grow at the same rate as capital requirements for credit risk. 21

Implementation Credit risk, Foreign exchange risk, Interest rate risk, Income and capital modeling. 22

Credit Risk Assumptions about credit growth projection are employed: Expected Loss is calculated; EL=EAD*PD*LGD – EAD=Exposure at Default, PD Probability of default, LGD Loss given defaul.t Non performing loans are projected based on expected PD. Capital requirements are calculated by Basel II formulas. 23

Basel II Concept for Credit Risk Under scenarios: PDs increase, Risk weighted assets could increase due to higher PD or decrease due to deleveraging. Banks use their incomes to keep the capital adequacy ratio at the same level. 24

Foreign Exchange Risk Total net open foreign exchange position: On balance sheet, Off balance sheet. Foreign exchange shock based on the given scenario, Foreign exchange risk = foreign exchange shock*total net open foreign exchange position. 25

Interest Rate Risk Change in values: On balance sheet, Off balance sheet. Assets held to maturity are deducted from total assets. Interest rate shock based on the given scenario. IR risk = IR shock*average duration*value of securities* (I- share of assets held to maturity). 26

Income and Capital Modeling Income Net income and net non-interest income is projected as an average of the last 3Y, Impact of IR change is considered under the baseline scenario, Total net expected income after the above shocks, Income – the first level of defense against the shocks. Capital after shock is considered under baseline and adverse scenarios. 27

Task and Allocation to Groups Group Work 3 Working Groups (A,B and C) Allocation of Tasks to Working Groups Discussion of Results 28

Task and Allocation to Groups 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, – Projections of credit risk parameters – (PD and LGD), – Assessment of other risks. 29

Task and Allocation to Groups 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: – 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. 30

Task and Allocation to Groups 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 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? 31

S TRESS TESTS : C HALLENGES AND FURTHER WORK 32

Stress tests: Challenges and further work 33

Stress tests: Challenges and further work Quality of underlying data, Improvements required in scenario design, Better methodologies required to account for: – Nonlinearities, – Structural breaks, – Contagion and, – Feedback effects. 34

Stress tests: Challenges and further work Central banks in the short term need to conduct stress tests on a more regular basis and include them as part of the general macroprudential analysis framework. It is important to include cross - border exposure and associated risks in stress testing. Countries need to develop macro - financial stress testing models and start to consider forecasting model projections as inputs to the analysis. 35

Stress tests: Challenges and further work 36

THANK YOU AND ENJOY THE DISCUSSION 37