Banking sector stress test methodology
Alternative macroeconomic scenarios serve as the starting point for stress testing. They 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. A “stress scenario”, or Adverse Scenario, is constructed based on the identification of risks to the Czech economy in the near future. The most probable macroeconomic developments are described by a Baseline Scenario. It is based on the first two years of the CNB’s official forecast published in the Inflation Report, while the third year – like the entire Adverse Scenario – is modelled solely for stress testing purposes.
The predictions for GDP growth, inflation and other macroeconomic variables for twelve quarters ahead (the stress testing horizon) 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 (loans to non-financial corporations, loans for house purchase to households, consumer credit and other loans), whereas the credit growth models are used to estimate the evolution of bank portfolios in relation to the macroeconomic situation and are used to estimate the evolution of risk-weighted assets (RWA).
In the stress tests, the prediction for macroeconomic and financial variables is reflected directly in the main balance-sheet and flow indicators of banks. The tests are dynamic, i.e. for each asset, liability, income and expenditure item 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 twelve 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. 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 set at different amounts for different scenarios and different credit segments in line with the projected economic developments, including 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 determined using the credit growth model.
An increase in the PD and LGD risk parameters has two main effects on individual banks.
First, the expected loan losses, 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 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 twelve 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 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 as defined by 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 this 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.3
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 holdings4. 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 rates).
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 ratio 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. If these losses are relatively high and will lead to a reduction in the bank’s capital ratio 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” has been constructed. This is calculated as interest profit plus fee profit minus administrative expenses and some other cost items. The amount of adjusted operating profit is determined for the individual scenarios according to the projected economic developments5.
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 ratio if its previous year’s profits are sufficient. Depending on the change in RWA, several scenarios are thus possible:
- the bank distributes the entire profit and does not strengthen its regulatory capital (in the event of unchanged RWA);
- 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);
- 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 ratio;
- 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.
The total capital ratio is then calculated for the individual quarters as the ratio of total RWA to total 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.
1This means, for example, that losses that will be reflected in a fall in profit (a flow indicator) will also be reflected in the same amount in total assets (a stock indicator).
2Risk-weighted assets = capital requirements (in CZK millions) × 12.5.
3The PD and LGD values determining capital requirements differ from the PD and LGD values used to calculate credit losses
4At the same time, however, interest rate changes have an indirect effect on credit risk via their effect on the PD estimate.
5Adjusted operating income 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 income does not include the effects of other (interest rate and currency) shocks, while pre-provision income does.