A Framework for Macroprudential Bank Solvency Stress Testing: Application to S-25 and Other G-20 Country FSAPs

Abstract

The global financial crisis has placed the spotlight squarely on bank stress tests. Stress tests conducted in the lead-up to the crisis, including those by IMF staff, were not always able to identify the right risks and vulnerabilities. Since then, IMF staff has developed more robust stress testing methods and models and adopted a more coherent and consistent approach. This paper articulates the solvency stress testing framework that is being applied in the IMF's surveillance of member countries' banking systems, and discusses examples of its actual implementation in FSAPs to 18 countries which are in the group comprising the 25 most systemically important financial systems ("S-25") plus other G-20 countries. In doing so, the paper also offers useful guidance for readers seeking to develop their own stress testing frameworks and country authorities preparing for FSAPs. A detailed Stress Test Matrix (STeM) comparing the stress test parameters applie in each of these major country FSAPs is provided, together with our stress test output templates.

Credibility and Crisis Stress Testing

“…The global financial crisis has brought to the fore risks which had previously been in the periphery or which had not been considered, such as exposures to sovereign and other previously low-default assets, their accounting in the banking or trading book, funding costs and cross-border exposures, among others (Jobst et al [21]). The U.S. stress test covered banks' entire balance sheets (including their international exposures) while the European stress tests focused on banks' domestic loan books (Table 8), which were the main concern of investors.…”

“…As a principle, stress scenarios should capture extreme but plausible shocks, i.e., the tail risks for the financial system (BCBS [12]; IMF [3]). However, while this principle should always be applied in stress tests for surveillance purposes to support discussions on supervisory actions and crisis preparedness (Jobst et al [21]) and in regular supervisory stress tests, it needs to be more nuanced in a crisis situation.…”

“…It should also be noted that caveats apply to the use of financial markets indicators to define the effectiveness of the stress tests in that they may also be influenced by other concurrent events which we do not isolate in this study. Source: Jobst et al [21]; Notes:…”

“…Ideally, a bottom-up (BU) test, cross-validated by a top-down (TD) exercise, would be the superior approach (IMF [3]; Jobst et al [21]), but this may not be possible in a crisis situation where the timeframe is compressed (see Figure 1, Note 1 for IMF staff's definitions of BU and TD stress tests). Both BU and/or TD approaches have been used effectively in crisis stress tests.…”

“…The coverage of banks should capture at least the systemically important institutions, given the macroprudential nature of the stress test (see IMF [3]; Jobst et al [21]). In this respect, guidance has been provided by the FSB on what constitutes global and domestic systemically important banks (BCBS [40,41]).…”