A Macro Stress Testing Framework
Workshop on Banking and Finance
16-20 April 2012
Christine Balzan
Senior Economist
Stress Testing and Risk Models
Presentation Overview

Introduction

Main sources of risk

Risk management and tools for monitoring risks

Macro stress testing
Introduction (1)

Controlling systemic risk has proved to be of
fundamental importance

Regulatory authorities have increased efforts in
developing and improving the set of tools and models
aimed at strengthening macro prudential analysis
Main Sources of Risk


Institutions face the following sources of risk:

Operational risk

Liquidity risk

Market risk

Credit risk
Other sources of risk include:

Reputational risk

Compliance risk

Country risk
Operational Risk

‘The risk of loss resulting from inadequate or failed
processes, people and systems or from external events.’

Risk events include:

Internal and/or external fraud

Damage to physical assets

Business disruption and business failure

Rogue Trading
Liquidity Risk
‘‘ Liquidity is the ability to fund increases in assets to
meet obligations as they come due without incurring
unacceptable losses’’
Bank for International Settlements (2008)

Liquidity risk emanates from two sources:

Funding liquidity risk

Liquidity risk from market sources
Market Risk

Market risk is the risk that the value of an investment will
be negatively affected by movements in market factors

Market risk arises from a number of sources namely:

Interest rate risk

Foreign exchange risk

Commodity risk

Equity risk
Credit Risk

Credit risk is the risk to a bank’s earnings or capital base arising
from the failure of the borrower to honour part or all of its debts
and where repayment depends on the performance of
counterparty issuer or borrower

Credit risk is perhaps the most significant source of risk given
the composition of banks’ portfolios
Risk Management Tools (1)

Allow the identification of a source of risk at an early stage
thereby enabling the prioritization of managing and mitigating
the impact of such risks, or indeed avoiding the materialising of
risk and its eventual adverse impact on the stability of the
financial system

Provide answers to ‘what if?’ scenarios thereby assisting in the
management of risks and taking the necessary actions in case
such risks occur
Risk Management Tools (2)
Risk management is a continuous process which:

Primarily identifies sources of risk

Analyzes and prioritizes risk

Develops and implements risk mitigation

Develops action plans to be implemented should a risk
event occur

Assures risk information is communicated to all institution
levels
Stress Testing (1)

Stress testing is a tool used to assess the resilience of an
institution to extreme yet plausible shocks to the macroeconomy and financial markets. Stress tests are part the risk
management toolkit used for detecting vulnerabilities in the
financial system
Central Bank of Malta
Stress Testing (2)

Is a form of testing used to determine the ability of an institution
to withstand hypothetical shocks. It tests beyond normal
operating capacity as it applies an extreme yet plausible shock to
an institution’s portfolio

The aim of stress tests is not to forecast the likelihood of a shock
materialising but to determine its magnitude or impact on the
financial system should it occur

Types of tests

Sensitivity tests

Scenario analysis
Stress Testing (3)
Unexpected
loss
Stress Testing (4)

Stress testing is especially important after long periods of
benign macro-economic and financial conditions when
fading memory of adverse conditions can lead to
complacency and under pricing or risk

Stress tests are used to support a range of decisions such as:

setting a risk profile or risk tolerance and exposure limits

feed into the capital and liquidity planning procedures

facilitate the development of risk mitigation and contingency
plans across a range of stressed conditions
Macro Stress Testing Process (1)
‘identification of possible events or future changes in
economic conditions that could have unfavourable effects on
a bank’s credit exposures and assessment of the bank’s
ability to withstand such changes’
Basel II Art. 434
The factors that can create extraordinary losses in banks’
portfolios include ‘low-probability events in all major types
of risk, including the various components of market, credit
and operational risks.’
Macro Stress Testing Process (2)

A macro stress testing process:

Set the macro-economic scenario

Link to banks (ex: through NPLs)

Conduct stress test

Recommendations
Macro Stress Testing Process (3)
Exogenous
shocks
Impact on
default
rates
Impact
on the
Macroeconomy
Impact on
bank’s earnings
Impact on
asset prices
Feedback effects
Impact on
banks’
capital
levels
Conclusion

Even though stress tests have been criticised, they still continue
to be an integral part of the risk management tool kit

Future improvements include:

Constantly reviewing scenarios and looking for new
extreme ones

Examining new products and identifying potential risks

Evaluating feedback effects

Improving correlations and interactions between market,
credit and liquidity risk
Thank you
balzanc@centralbankmalta.org