A Guide to IMF Stress Testing
Front Matter

Front Matter

Author(s):
Li Ong
Published Date:
December 2014
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    A Guide to IMF Stress Testing

    Methods and Models

    Editor

    Li Lian Ong

    ©2014 International Monetary Fund

    Cover design: IMF Multimedia Services Division

    Cataloging-in-Publication Data

    Joint Bank-Fund Library

    A guide to IMF stress testing: methods and models / editor, Li Lian Ong. —

    Washington, D.C.: International Monetary Fund, 2014.

    p.; cm.

    Includes bibliographical references and index.

    1. Financial crises. 2. Banks and banking, International. 3. International Monetary Fund. I. Ong, Li Lian. II. International Monetary Fund.

    HB3725.G84 2014

    ISBN: 978-1-48436-858-9 (paper)

    ISBN: 978-1-47555-129-7 (web PDF)

    Disclaimer: The views expressed in this book are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

    Please send orders to:

    International Monetary Fund, Publication Services

    P.O. Box 92780, Washington, DC 20090, U.S.A.

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    For

    Mark W. Swinburne

    June 17, 1955–September 3, 2009

    Assistant Director

    Monetary and Capital Markets Department

    International Monetary Fund

    Manager, mentor, friend

    Contents

    Foreword

    The global financial crisis has placed a spotlight on the stress testing of financial systems. Although weaknesses in stress tests were exposed by the crisis, the recent experience of several countries has conversely provided a stark illustration of their potential benefit in examining the resilience of bank balance sheets when performed credibly and transparently. Nonetheless, the large menu of stress testing approaches, methods, and models raises questions about their appropriate application under different situations and, consequently, the comparability and reliability of the associated analyses.

    The International Monetary Fund (IMF) has had a long and unique involvement in the stress testing of financial systems. Since the introduction of the Financial Sector Assessment Program (FSAP) more than a decade ago, IMF staff has conducted stress tests of banking sectors in over 120 countries, typically in close collaboration with country authorities. Stress testing is also playing an increasingly important role in the IMF’s multilateral surveillance, through the analysis in our Global Financial Stability Report. Separately, member countries are increasingly requesting IMF technical assistance in stress testing as they develop their own expertise in this area. As a result, our staff has amassed a wealth of hands-on experience with stress testing techniques and their practical application.

    This book represents a compendium of stress testing methods, models, and tools developed or adapted by IMF staff over the years. Almost all the methods and models that are included in this volume have, at one time or another, been applied in our surveillance of, or our technical assistance to, member countries. To guide users, each chapter offers a summary describing the application of a method or model, its strengths and weaknesses, and the data requirements. Where available, the stress testing tools or program codes are also provided for wider public use.

    Although I trust that this volume will provide a valuable resource for policymakers, supervisors, academics, and private sector participants alike, caveats still apply. The crisis has underscored that stress tests, irrespective of their level of sophistication, are not fail-safe, stand-alone diagnostic tools. Assessments of the soundness of any financial system cannot and should not be based solely on a “model” and must be complemented by other quantitative analyses, qualitative information, and, most important, expert judgment. Especially in light of evolving market practices, risks, and regulatory requirements, stress testing will necessarily continue to be art rather than science.

    IMF staff is continually working to strengthen the analytical underpinnings of its stress testing, in ways that will help bolster its consistency and comparability and hence its credibility. Key areas of focus include extending the analysis to better cover nonbank financial institutions and infrastructures; to take account of spillovers between institutions and across borders; to consider the interaction between liquidity and solvency risks; and to address data gaps. In addition, IMF staff is developing the policy-related aspects of stress testing, namely, “best practice” principles, concepts, and frameworks, to complement and strengthen the application of the models. These efforts represent a challenging and exciting part of the IMF’s broader support of global efforts to improve financial surveillance and promote sound macroprudential frameworks.

    JOSÉ VIÑALS

    Financial Counsellor and Director

    Monetary and Capital Markets Department

    International Monetary Fund

    Acknowledgments

    I am grateful to the many contributing authors of this book. The papers that make up the many chapters of this volume are the result of collaboration among internal colleagues and external experts, and have benefited from comments from IMF staff, academics, market participants, and policymakers, as well as journal editors and referees.

    This project would not have been possible without the backing of José Viñals. And my heartfelt thanks to my colleague, friend, and sometime co-author, Martin Čihák, for his support and sage advice throughout this venture.

    The book has also benefited greatly since its inception from the professionalism and expertise of colleagues in the Communications Department, specifically, Sean Culhane, Patricia Loo, and Joanne Johnson.

    Last but not least, I would like to thank Margarita Aguilar for her indispensable and patient assistance in the preparation of the manuscript; and James Morsink and Srobona Mitra for back-stopping me during the publication process.

    Abbreviations

    ABO

    accrued benefit obligation

    ABS

    asset-backed security

    AIB

    Allied Irish Banks PLC

    AIG

    American International Group

    AIRB

    Advanced Internal Ratings Based

    Anglo IB

    Anglo Irish Bank Corp. PLC

    ARCH

    autoregressive conditional heteroskedasticity

    ASF

    available stable funding

    BBVA

    Banco Bilbao Vizcaya Argentaria

    BCBS

    Basel Committee on Banking Supervision

    BCCH

    Central Bank of Chile/Banco Central de Chile

    BCP

    Basel Core Principles for Banking Supervision

    BHC

    bank holding company

    BIS

    Bank for International Settlements

    BoE

    Bank of England

    BoI

    Bank of Ireland

    BSI

    Banking Stability Index

    BSM

    banking stability measure

    BSMD

    Banking System’s (portfolio) Multivariate Density

    BSoM

    Black-Scholes-Merton

    BU

    bottom-up

    CAPM

    capital asset pricing model

    CAR

    capital adequacy ratio (regulatory capital to risk-weighted assets)

    CCA

    contingent claims analysis

    CCP

    Copula Choice Problem

    CDO

    collateralized debt obligation

    CDS

    credit default swap

    CEBS

    Committee of European Banking Supervisors

    CEDF

    cumulative expected default frequency

    CESE

    Central, Eastern, and Southern Europe

    C&I

    commercial and industrial

    CIMDO

    Consistent Information Multivariate Density Optimizing

    CN

    capital need

    CNB

    Croatian National Bank

    CoPoD

    Conditional Probability of Default

    CPI

    consumer price index

    CRE

    commercial real estate

    CRI

    credit risk indicator

    CRT

    credit risk transfer

    CSFP

    Credit Suisse Financial Products

    DAX

    Deutscher Aktien IndeX

    DB

    defined benefit

    DCC

    dynamic conditional correlation

    DD

    distance to default

    DiDe

    Distress Dependence Matrix

    DNB

    De Nederlandsche Bank

    DSI

    debt service-to-income ratio

    DTA

    deferred tax assets

    DtD

    distance to distress

    EAD

    exposure at default

    EC

    economic capital

    ECB

    European Central Bank

    EDF

    expected default frequency

    EL

    expected loss

    EMBI+

    Emerging Market Bond Index

    EMBIG

    Emerging Market Bond Index Global

    ES

    expected shortfall

    EU

    European Union

    EVT

    extreme value theory

    FFT

    fast Fourier transform

    FIRB

    Foundation Internal Ratings Based

    FME

    Financial Supervisory Authority/Fjármálaeftirlitsins

    FMI

    financial market infrastructure

    FSAP

    Financial Sector Assessment Program

    FSB

    Financial Stability Board

    FSC

    Financial Services Center

    FSI

    financial soundness indicator

    FSR

    Financial Stability Report

    FVCDS

    fair value CDS

    FVOAS

    fair value option adjusted spread

    FX

    foreign exchange

    GARCH

    generalized autoregressive conditional heteroskedasticity

    GEV

    generalized extreme value

    GFSR

    Global Financial Stability Report

    GMM

    Generalized Method of Moments

    GOB

    Government of Brazil

    HBOS

    Halifax Bank of Scotland

    HHI

    Herfindahl-Hirschman Index

    HSBC

    Hongkong and Shanghai Banking Corporation

    IBB

    immediate borrower basis

    ICR

    interest coverage ratio

    IFRS

    International Financial Reporting Standards

    IFS

    International Financial Statistics

    IMACEC

    Indicador Mensual de Actividad Económica

    IPSA

    Indice de Precios Selectivo de Acciones

    IRB

    Internal Ratings Based

    IRF

    impulse response function

    ISEQ

    Irish Stock Exchange Overall Index

    IT

    information technology

    JPoD

    joint probability of distress

    KMV

    Kealhofer, McQuown, and Vasicek (a part of Moody’s Analytics)

    LCR

    liquidity coverage ratio

    LGD

    loss given default

    LHS

    left-hand side

    LIBOR

    London Interbank Offered Rate

    LLR

    loan loss reserve

    LS

    least squares

    LTCM

    Long Term Capital Management

    LTV

    loan-to-value

    MCAR

    market-implied capital adequacy ratio

    MES

    marginal expected shortfall

    MfRisk

    Macro-Financial Risk

    MGF

    moment generating function

    MIDP

    market implied default probabilities

    MKMV

    Moody’s KMV

    ML

    maximum likelihood

    MPS

    macroprudential policy and surveillance

    MSCI

    Morgan Stanley Capital International

    MSE

    mean squared error

    MXED

    minimum cross-entropy distribution

    NASDAQ

    National Association of Securities Dealers Automated Quotations

    NBB

    National Bank of Bankistan

    NBFI

    nonbank financial institution

    NFI

    net foreign investment

    NPL

    nonperforming loan

    NSFR

    net stable funding ratio

    OBS

    off-balance-sheet

    OeNB

    Austrian National Bank/Oesterreichische Nationalbank

    OIS

    overnight indexed swap

    OLS

    ordinary least squares

    OOM

    out-of-the-money

    PAO

    probability that at least one bank becomes distressed

    PBO

    projected benefit obligation

    PBOcd

    projected benefit obligation constant dollar

    PCA

    principal component analysis

    PD

    probability of default

    PGF

    probability generating function

    PIT

    Probability Integral Transformation

    PLD

    profit and loss distribution

    PMD

    portfolio multivariate distribution

    PoD

    probability of distress

    QIRB

    quasi-Internal Ratings Based

    QIS

    Quantitative Impact Study

    RAMSI

    Risk Assessment Model for Systemic Institutions

    RHS

    right-hand side

    RBO

    retirement benefit obligation

    RBS

    Royal Bank of Scotland

    RNDP

    risk-neutral default probability

    RNS

    risk-neutral credit spread

    ROA

    return on assets

    RRE

    residential real estate

    RSF

    required stable funding

    RWA

    risk-weighted assets

    SAS

    stand-alone subsidiarization

    SBIF

    Banking Supervisory Agency/Superintendencia de Bancos e Instituciones Financieras

    SCAP

    Supervisory Capital Assessment Program

    SELIC

    Sistema Especial de Liquidação e Custodia

    SLOOS

    Senior Loan Officer Opinion Survey of Bank Lending Practices

    SME

    small-and medium-sized enterprise

    S&P

    Standard and Poor’s

    SPD

    state-price density

    SRL

    Systemic Risk-Adjusted Liquidity

    SRM

    Systemic Risk Monitor

    StA

    Standardized Approach

    SWF

    sovereign wealth fund

    TARP

    Troubled Asset Relief Program

    TBTF

    too-big-to-fail

    TCTF

    too-connected-to-fail

    TD

    top-down

    TMTF

    too-many-to-fail

    TTC

    through-the-cycle

    UL

    unexpected loss

    URB

    ultimate risk basis

    VaR

    value at risk

    VAR

    vector autoregression

    VDAX

    implied volatility of the Deutscher Aktien IndeX (DAX)

    VIX

    Chicago Board Options Exchange Market Volatility Index (implied volatility of the S&P 500 index)

    WaMu

    Washington Mutual

    WEO

    World Economic Outlook

    Contributing Authors

    IMF Staff (past and present)

    Renzo G. Avesani, Senior Economist, Monetary and Capital Markets Department. Currently Chief Risk Officer, Unipol Gruppo Finanziario (renzo.avesani@unipol.it).

    Eugenio Cerutti, Senior Economist, Research Department (ecerutti@imf.org).

    Jorge A. Chan-Lau, Senior Economist, Monetary and Capital Markets Department (jchanlau@imf.org). Currently Visiting Faculty, Robert H. Smith School of Business, University of Maryland and Senior Research Fellow, Risk Management Institute, National University of Singapore.

    Martin Čihák, Advisor, Monetary and Capital Markets Department (mcihak@imf.org).

    Elena Duggar, Economist, Monetary and Capital Markets Department. Currently Group Credit Officer, Moody’s Investors Service (elena.duggar@moodys.com).

    Nombulelo Duma, Senior Economist, Monetary and Capital Markets Department (nduma@imf.org).

    Marco A. Espinosa-Vega, Deputy Division Chief, Institute for Capacity Development (mespinosa@imf.org).

    Michael T. Gapen, Economist, IMF Institute. Currently Managing Director, U.S. Economic Research, Barclays (michael.gapen@barclays.com).

    Dale F. Gray, Senior Risk Expert, Monetary and Capital Markets Department (dgray@imf.org).

    Maher Hasan, Deputy Division Chief, Monetary and Capital Markets Department. Currently Deputy Governor, Central Bank of Jordan (maher.hasan@cbj.gov.jo).

    Heiko Hesse, Senior Economist, Strategy, Policy and Review Department (hhesse2@imf.org).

    Anna Ilyina, Advisor, European Department (ailyina@imf.org).

    Gregorio Impavido, Senior Economist, European Department (gimpavido@imf.org).

    Andreas A. Jobst, Senior Economist, European Department (ajobst@imf.org).

    Geoffrey N. Keim, Economist, Western Hemisphere Department (gkeim@imf.org).

    Cheng Hoon Lim, Assistant Director, Monetary and Capital Markets Department (clim@imf.org).

    Kexue Liu, Scientific Analyst, Technology and General Services Department. Currently Quant Programmer, Tradeweb Markets LLC (Kexue.Liu@tradeweb.com).

    Andrea M. Maechler, Deputy Division Chief, Monetary and Capital Markets Department (amaechler@imf.org).

    Rodolfo Maino, Senior Economist, African Department (rmaino@imf.org).

    Yulia Makarova, Research Assistant, Monetary and Capital Markets Department. Currently Consultant, UNICEF (ymakarova@gmail.com).

    Alin Mirestean, Section Chief, Technology and General Services Department (amirestean@imf.org).

    Srobona Mitra, Senior Economist, Monetary and Capital Markets Department (smitra@imf.org).

    Li Lian Ong, Deputy Division Chief, Monetary and Capital Markets Department. Currently Senior Vice President, Economics and Investment Strategy, GIC Private Limited (onglilian@gic.com.sg).

    Marta Ruiz-Arranz, Deputy Division Chief, Fiscal Affairs Department (mruizarranz@imf.org).

    Jean Salvati, Information Technology Officer, Technology and General Services Department. Currently Director of Product Management, Primatics Financial (jean.salvati@gmail.com).

    Christian Schmieder, Economist, Monetary and Capital Markets Department. Currently Member of Secretariat, Basel Committee on Banking Supervision (Christian.Schmieder@bis.org).

    Liliana Schumacher, Senior Economist, Monetary and Capital Markets Department (lschumacher@imf.org).

    Miguel A. Segoviano, Deputy Division Chief, Monetary and Capital Markets Department (msegoviano@imf.org).

    Juan Solé, Senior Economist, Western Hemisphere Department (jsole@imf.org).

    Marcos Souto, Financial Sector Expert, Monetary and Capital Markets Department (msouto@imf.org).

    Alexander F. Tieman, Senior Economist, European Department (atieman@imf.org).

    Francisco Vazquez, Senior Economist, European Department (fvazquez@imf.org).

    James P. Walsh, Deputy Division Chief, Monetary and Capital Markets Department (jwalsh@imf.org).

    Torsten Wezel, Senior Economist, Monetary and Capital Markets Department (twezel@imf.org). Currently Principal Financial Sector Expert, European Central Bank (torsten.wezel@ecb.int).

    Yingbin Xiao, Senior Economist, European Department (yxiao2@imf.org).

    External Coauthors

    Theodore Barnhill Jr., Professor of Finance, George Washington University (barnhill@gwu.edu).

    Michel Canta, Deputy Superintendent of Private Pension Funds, Superintendence of Banking, Insurance, and Private Pension Funds of Peru (mcanta@sbs.gob.pe).

    Charles A. E. Goodhart, Professor, Financial Markets Group, London School of Economics (c.a.goodhart@lse.ac.uk).

    Manuel Luy, Head, Research Department, Superintendence of Banking, Insurance, and Private Pension Funds of Peru (mluy@sbs.gob.pe).

    Benjamin Neudorfer, Analyst, Stress Tests and Strategy Unit, Supervision Policy, Regulation and Strategy Division, Oesterreichische Nationalbank (benjamin.neudorfer@oenb.at).

    Pablo Padilla, Professor of Mathematics and Mechanics, Universidad Nacional Autonoma de México (Pablo@mym.iimas.unam.mx).

    Claus Puhr, Head, Stress Tests and Strategy Unit, Supervision Policy, Regulation and Strategy Division, Oesterreichische Nationalbank (claus.puhr@oenb.at).

    Stefan W. Schmitz, Head, Macroprudential Analysis Unit, Financial Stability and Macroprudential Supervision Division, Oesterreichische Nationalbank (stefan.schmitz@oenb.at).

    Benjamin M. Tabak, Legislative Advisor, Federal Senate of Brazil (benjamim.tabak@gmail.com); Professor of Banking and Finance and Law and Economics, Catholic University of Brasilia; and CNPQ Foundation.

    Disclaimer

    The views expressed in this volume are those of the authors and do not necessarily represent those of their respective institutions.

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