Title Page

A Guide to IMF Stress Testing

Methods and Models

Editor

Li Lian Ong

Copyright

©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:

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Frontmatter Page

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

• José Viñals

• Acknowledgments

• Abbreviations

• Contributing Authors

  • • 1. Stress Testing at the International Monetary Fund: Methods and Models

      • Li Lian Ong • Martin Čihák

• PART I THE ACCOUNTING-BASED APPROACH

  • A. THE BALANCE SHEET-BASED APPROACH

    • 2. Introduction to the Balance Sheet-Based Approach to Stress Testing

      • Christian Schmieder • Liliana Schumacher

    • 3. Stress Tester: A Toolkit for Bank-by-Bank Analysis with Accounting Data

      • Martin Čihák

    • 4. Into the Great Unknown: Stress Testing with Weak Data

      • Li Lian Ong • Rodolfo Maino • Nombulelo Duma

    • 5. Next-Generation Applied Solvency Stress Testing

      • Christian Schmieder • Claus Puhr • Maher Hasan

    • 6. Of Runes and Sagas: Perspectives on Liquidity Stress Testing Using an Iceland Example

      • Li Lian Ong • Martin Čihák

    • 7. Next-Generation Systemwide Liquidity Stress Testing

      • Christian Schmieder • Heiko Hesse • Benjamin Neudorfer • Claus Puhr • Stefan W. Schmitz

    • 8. Systemic Bank Risk in Brazil: A Comprehensive Simulation of Correlated Market, Credit, Sovereign, and Interbank Risks

      • Theodore Barnhill Jr. • Marcos Souto

    • 9. Modeling Correlated Systemic Bank Liquidity Risks

      • Theodore Barnhill Jr. • Liliana Schumacher

    • 10. Review and Implementation of Credit Risk Models

      • Renzo G. Avesani • Kexue Liu • Alin Mirestean • Jean Salvati

    • 11. Bankers without Borders? Implications of Ring-Fencing for European Cross-Border Banks

      • Eugenio Cerutti • Anna Ilyina • Yulia Makarova • Christian Schmieder

    • 12. Conducting Stress Tests of Defined Benefit Pension Plans

      • Gregorio Impavido

  • B. THE NETWORK ANALYSIS APPROACH

    • 13. Introduction to the Network Analysis Approach to Stress Testing

      • Marco A. Espinosa-Vega • Juan Solé

    • 14. Cross-Border Financial Surveillance: A Network Perspective

      • Marco A. Espinosa-Vega • Juan Solé

    • 15. Balance Sheet Network Analysis of Too-Connected-to-Fail Risk in Global and Domestic Banking Systems

      • Jorge A. Chan-Lau

• PART II THE MARKET PRICE-BASED APPROACH

  • A. THE EQUITY INDICATORS-BASED APPROACH

    • 16. Introduction to the Equity Indicators-Based Approach to Stress Testing

      • Jorge A. Chan-Lau

    • 17. The Global Financial Crisis and Its Impact on the Chilean Banking System

      • Jorge A. Chan-Lau

    • 18. Regulatory Capital Charges for Too-Connected-to-Fail Institutions: A Practical Proposal

      • Jorge A. Chan-Lau

  • B. THE EXTREME VALUE THEORY APPROACH

    • 19. Introduction to the Extreme Value Theory Approach to Stress Testing

      • Srobona Mitra

    • 20. External Linkages and Contagion Risk in Irish Banks

      • Elena Duggar • Srobona Mitra

    • 21. Identifying Spillover Risk in the International Banking System: An Extreme Value Theory Approach

      • Jorge A. Chan-Lau • Martin Čihák • Srobona Mitra • Li Lian Ong

  • C. THE CONTINGENT CLAIMS ANALYSIS APPROACH

    • 22. Introduction to the Contingent Claims Analysis Approach for Stress Testing

      • Dale F. Gray • Andreas A. Jobst • Cheng Hoon Lim • Yingbin Xiao

    • 23. Vulnerabilities of Household and Corporate Balance Sheets in the United Kingdom and Risks for the Financial Sector

      • Marta Ruiz-Arranz

    • 24. Measuring and Analyzing Sovereign Risk with Contingent Claims

      • Michael T. Gapen • Dale F. Gray • Cheng Hoon Lim • Yingbin Xiao

    • 25. Factor Model for Stress Testing with a Contingent Claims Model of the Chilean Banking System

      • Dale F. Gray • James P. Walsh

    • 26. Systemic Contingent Claims Analysis

      • Andreas A. Jobst • Dale F. Gray

    • 27. Measuring Systemic Risk-Adjusted Liquidity

      • Andreas A. Jobst

• PART III THE MACRO-FINANCIAL APPROACH

  • • 28. Introduction to the Macro-Financial Approach to Stress Testing

      • Andrea M. Maechler

    • 29. A Macro Stress Test Model of Credit Risk for the Brazilian Banking Sector

      • Francisco Vazquez • Benjamin M. Tabak • Marcos Souto

    • 30. A Practical Example of the Nonperforming Loans Projection Approach to Stress Testing

      • Torsten Wezel • Michel Canta • Manuel Luy

    • 31. Portfolio Credit Risk and Macroeconomic Shocks: Applications to Stress Testing under Data-Restricted Environments

      • Miguel A. Segoviano • Pablo Padilla

    • 32. Banking Stability Measures

      • Miguel A. Segoviano • Charles A. E. Goodhart

    • 33. A Forward-Looking Macroprudential Stress Test for U.S. Banks

      • Geoffrey N. Keim • Andrea M. Maechler

    • 34. The Real Effects of Financial Sector Risk

      • Alexander F. Tieman • Andrea M. Maechler

• Index

  • TOOLKIT CONTENTS

• The files listed below are available on the companion CD and at www.elibrary.imf.org/stress-test-toolkit.

  • Chapter 3

  • Stress Tester 3.0

  • Chapter 4

  • Excel Spreadsheet Macro for the Breaking Point Method

  • Chapter 5

  • Excel Spreadsheet Macro for the Next-Generation Solvency Stress Test

  • Chapter 6

  • Excel Spreadsheet Macro for the Market and Funding Liquidity Stress Test

  • Chapter 7

  • Excel Spreadsheet Macro for the Next-Generation Systemwide Liquidity Stress Test

  • Chapter 10

  • Excel Add-in for the CreditRisk+ Model

  • Chapter 12

  • Excel Spreadsheet Macro for Stress Testing Defined Benefit Pension Plans

  • Chapter 14

  • Excel-based Program for Bank Network Analysis

  • Chapter 20

  • Example Eviews Program Codes: External Linkages

  • Chapter 21

  • Example Eviews Program Codes: International Banking System

  • Chapter 24

  • Excel Spreadsheet for the Balance Sheet Risk Analysis

  • Chapter 33

  • Excel Spreadsheet Macro for Forward-Looking Macroprudential Stress Test

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

Contributing Authors