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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www.imfbookstore.org

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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