Banking sector stress test methodology
Banking sector stress tests are used at the CNB as a tool for assessing the resilience of the banking sector as a whole to potential adverse shocks.
Alternative macroeconomic scenarios
Alternative macroeconomic scenarios serve as the starting point for stress testing. The scenarios are designed using the CNB’s official prediction model supplemented with an estimate of the evolution of some additional variables, which are not directly generated by the model. “Stress scenarios” are constructed based on the identification of risks to the Czech economy in the near future. To compare the stress outcome with the most probable outcome, the stress tests use a baseline scenario, i.e. the current official macroeconomic prediction of the CNB.
The predictions for GDP growth, inflation and other macroeconomic variables for the next eight quarters enter credit risk and credit growth models. The credit risk models are used to predict the main credit risk parameters, in particular the probability of default (PD) for the four main credit segments (non-financial corporations, loans to households for house purchase, consumer credit and other loans), whereas the credit growth models are used to estimate the growth in bank portfolios in relation to the macroeconomic situation and are used (after certain adjustments) to estimate the evolution of risk-weighted assets (RWA).
In the stress tests, the prediction for macroeconomic and financial variables for individual quarters is reflected directly in the prediction for the main balance-sheet and flow indicators of banks. The tests are dynamic, i.e. for each item of assets, liabilities, income and expenditure there is an initial (the last actually known) stock, to which the impact of the shock in one quarter is added/deducted, and this final stock is then used as the initial stock for the following quarter. This logic is repeated in all eight quarters for which the prediction is being prepared. The changes in flow and stock variables are modelled in a consistent manner1.
Credit risk testing is the most important area of stress testing. This testing is based on the use of PD for each of the four main segments of the loan portfolio. The second credit risk parameter is the loss given default (LGD), which is determined by expert judgement, with different amounts being set for different scenarios and different credit segments in line with the projected economic development including the house prices, regulatory rules, commercial bank practices, the approaches applied by some rating agencies and existing estimates based on market data. The third parameter is the exposure at default (EAD), which is also determined by expert judgement.
An increase in the PD and LGD risk parameters has two main effects on individual banks.
First, the expected loan losses (in CZK millions), against which banks will create new provisions of an equal amount and record them on the expenditure side of the profit and loss account as impairment charges, are calculated as the product of PD, LGD and EAD for each credit segment and quarter. Total assets are then symmetrically reduced by the amount of these expenditures.
PD is also used to predict the volume of the gross inflow of non-performing loans (NPLs). After taking into account a certain gross outflow of existing NPLs, it is thus possible to generate for each bank, and subsequently for the banking sector as a whole, the path of total NPLs in the following eight quarters.
The credit growth model leads to an estimate of the gross volume of loans in individual segments. Using the above NPL modelling, this allows us to determine for each bank, and subsequently for the banking sector as a whole, the NPL/total loans ratio, a standard and highly sought-after indicator of the banking sector’s health.
Second, in the case of banks applying the advanced approach to the calculation of capital requirements for credit risk under Basel II, the capital requirements (or RWA 2) for credit risk are a function of PD, LGD and EAD. Given that the largest banks in the Czech Republic apply the advanced approach, this relation is applied to all banks for the sake of simplicity. Given a constant portfolio volume, an increase in PD and LGD results in an increase in RWA.
Interest rate and currency risk
The macroeconomic scenarios contain a prediction of the evolution of the simplified koruna and euro yield curves (rates with 3M, 1Y and 5Y maturities). A change in interest rates has a direct effect on bank balance sheets in two main items, namely interest profit and the value of bond holdings3. A rise in short-term rates thus reduces the interest rate profit of those banks which have an excess of short-term liabilities over short-term assets. However, the calculation is adjusted by expert judgement to take account of the business policies of commercial banks, which respond relatively little to market interest rate changes on the deposit side. The prediction for longer interest rates is then used to estimate profits/losses from the revaluation of bond holdings (except for bonds held to maturity and bonds with a variable coupon linked to certain reference interest rate).
The quarter-on-quarter change in the CZK/EUR exchange rate is applied to the net open foreign currency position, generating either a loss (for example in the case of a positive open position and appreciation of the koruna, i.e. a decline in the koruna value of foreign currency assets) or a profit due to the change in the exchange rate (in the opposite case).
Interbank contagion risk
Interbank contagion risk is modelled on the basis of data on interbank exposures, with the capital adequacy of individual banks being used to determine their probability of default (PD). As interbank exposures are mostly unsecured, LGD is assumed to be 100%. The expected losses due to interbank exposures are calculated for each bank according to the formula PDxLGDxEAD, where EAD is the net interbank exposure. If these losses are relatively high and will lead to a reduction in the bank’s capital adequacy and thus an increase in its PD, there follows another iteration of the transmission of the negative effects to other banks through an increase in the expected losses. These iterations are performed until this “domino effect” of interbank contagion stops, i.e. until the rise in PD induced in one bank or group of banks does not lead to a rise in the PD of other banks.
Profit, regulatory capital and capital adequacy
The stress test assumes that banks will continue to generate revenues in the stress period, particularly net interest income (interest profit) and net fee income. For these purposes, an analytical item of the profit and loss account called “adjusted operating profit” (previously called “net income”) has been constructed. This is calculated as interest profit plus fee profit minus administrative expenses and some other cost items. The volume of adjusted operating profit is determined by expert judgment for the individual scenarios according to the projected economic development4.
Regulatory capital is modelled in accordance with the applicable CNB regulations. Each bank enters the first predicted quarter with initial capital equal to that recorded in the last available quarter. If a bank generates a profit in the first predicted quarter (i.e. its adjusted operating profit is higher than its losses due to the shocks), its regulatory capital remains at the same level (is not increased). If, however, it generates a loss, its regulatory capital is reduced by the amount of that loss. The impacts of the shocks are thus reflected in a reduction of capital only if they exceed adjusted operating profit and the bank posts a loss.
It is assumed that those banks which generate a profit for the entire financial year will decide on profit distribution and dividend payments in the second quarter of the following year. Here we assume that each bank, when increasing its capital from retained earnings of the previous financial year, will try to get to its initial capital adequacy ratio if its previous year’s profits are sufficient. Depending on the change in RWA, several scenarios are thus possible:
(a) the bank distributes the entire profit and does not strengthen its regulatory capital (in the event of unchanged RWA);
(b) the bank uses part of its profit to strengthen its capital and distributes the remainder (in the event of an increase in RWA; however, the entire retained earnings of the previous year will not be needed to reach the initial level of capital);
(c) the bank uses the entire profit to strengthen its capital (in the event of a relatively sizeable increase in RWA); depending on the size of the increase in RWA, however, it may not reach the original capital adequacy ratio;
(d) the bank pays dividends that exceed the profit generated (in the event of a decrease in RWA) and thereby also distributes part of retained earnings of previous years.
Total capital adequacy is then calculated for the individual quarters as the ratio of total RWA to regulatory capital. The portion of RWA relating to credit risk is modelled on the basis of the credit risk parameters (see above), while the other components of RWA (or of the capital requirements for other risks) for the individual quarters are determined by expert judgement.
Prepared by the CNB’s Financial Stability Department. Contact: financial.stability@cnb.
2Risk-weighted assets = capital requirements (in CZK millions) x 12.5.
3At the same time, however, interest rate changes have an indirect effect on credit risk via their effect on the PD estimate.
4Adjusted operating profit corresponds to a large extent to the item “pre-provision income”, i.e. operating income gross of NPL losses. However, they differ in that adjusted operating profit does not include the effects of other (interest rate and currency) shocks, while pre-provision income does.