- Li Lian Ong, and Andreas A. Jobst
- Published Date:
- September 2020
What do you do when you need to measure how shocks affect the financial system? You call in stress testers!
Stress testing is a crucial tool for measuring financial system resilience. It has been an indispensable component of financial stability assessments that the IMF staff carries out under the Financial Sector Assessment Program (FSAP). Stress tests have also become an integral part of financial stability analyses done by central banks, supervisory agencies, and many others.
The scope and design of stress tests have significantly evolved since the global financial crisis. The crisis demonstrated that the usefulness and effectiveness of stress testing depend on consistency, comparability, and coherence of methods and models. Stress tests can go wrong if they are based on weak, flawed, or incomplete data, omit crucial risks, or exclude important non-bank financial institutions and financial market infrastructures. At the same time, stress tests can provide extremely powerful insights into the financial system’s vulnerabilities if they are done credibly and transparently. It is therefore important for the design, implementation, and findings of stress tests to be well explained and well understood. That is why a book such as this one—focused on principles, concepts, and frameworks—is incredibly helpful.
The IMF has had a pioneering role in the stress testing of financial systems. Since the introduction of the FSAP by the IMF and the World Bank 20 years ago, the IMF staff has completed more than 350 financial stability assessments, including stress tests, in countries accounting for more than 99 percent of global financial system assets. As a result, the IMF staff has amassed a wealth of hands-on experience with stress testing techniques and their practical applications. Member countries have frequently requested IMF technical assistance developing their own stress testing approaches.
This anthology is a follow up to the 2014 book A Guide to IMF Stress Testing: Methods and Models. It assembles additional papers written by individual IMF staff members and their coauthors on the principles and concepts that have shaped the implementation of FSAP stress tests over the past eight years. (The papers collected in the volume reflect the work of the individual authors and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.) They capture much of the evolving anatomy of IMF stress testing by providing insights into the design, risk coverage, and practical implementation of stress tests for financial stability analysis and crisis management. These approaches have, at one time or another, been applied in IMF surveillance of, or technical assistance to, member countries. As in the 2014 book, some of the chapters are accompanied by available tools.
While this volume covers a substantial body of work, it is not exhaustive and has not been fully updated. The book does not include all of the studies produced by the IMF staf1 as well as work in progress and recent developments in stress testing as result of ongoing financial stability assessments. Moreover, empirical analyses underlying the chapters have not been updated, so the chapters should be seen as a series of snapshots capturing various vintages of work by individual IMF staff members and their coauthors, reflecting the issuance dates of the respective papers. All chapters were written before the COVID-19 crisis, and as such do not reflect lessons from the pandemic.
With these limitations in mind, let me highlight some areas of recent emphasis.2 The IMF staff has significantly stepped up work to strengthen the analytical underpinnings of stress tests. Key areas of recent focus include (1) incorporating feedback effects between the financial sector and the real economy; (2) further extending the coverage to nonbank financial institutions and financial markets; (3) improving models of spillovers among institutions and across borders; (4) developing new models for the interaction between liquidity and solvency risks; and (5) advancing agent-based modeling. The 2020 Review of the FSAP will be an opportunity to examine and report on some of these improvements as well as on emerging lessons from the COVID-19 crisis.
In addition to these efforts aimed at strengthening the analytical underpinnings of existing stress tests, the IMF staff has also explored new topics. This includes stress tests for emerging risks such as technological disruptions and climate change. Given the evolving nature of this work, these risks have not been covered in this book and also remain a work in progress at the I M F.
Technology-enabled innovation is disrupting the provision of financial services. The evolution of “Fintech” in bank and nonbank financial intermediation could weigh on profitability and liquidity and stoke risk taking. Recent IMF stress tests have started exploring these issues, for example, by examining how the rise of new financial technologies could squeeze the profits of existing financial service firms. Separately, the increased digitization of financial services can also expose them to cyber risk with possibly systemic consequences for financial intermediation. For instance, a major cyber event could lead to runs on deposits or claims against insurers. The IMF staff has been working collaboratively with external experts on stress testing for cyber risk.
Climate risk is a major systemic issue on which the IMF staff has been working intensely. FSAP stress tests often capture “physical risks,” such as insurance losses and nonperforming loans associated with storms, foods, and droughts. Over time, these tests have devolved from narrow exercises focusing on nonlife insurance companies to integrated assessments capturing the macro-financial effects. Several ongoing assessments are expanding on this analysis, examining the effects of increased frequency and costs of natural disasters as well as the risks involved in the transition to low-carbon economies. More work is still needed to better capture second-round effects and to fill the major data gaps in this area. The IMF staff collaborates with central banks and others to enhance the analysis of macro-financial transmission of climate risks, including through stress tests.
In sum, stress testing is an exciting, evolving, and important part of the broader effort to ensure financial stability. I trust that this volume will provide a valuable resource for central bankers, financial sector supervisors, other country officials, and academics as well as anyone interested in better understanding the concepts and principles that have been shaping stress testing approaches developed by the IMF staff.
Financial Counsellor and Director
Monetary and Capital Markets Department
International Monetary Fund
These are explained more fully in the recent Departmental Paper No. 20/04 titled “Stress Testing at the IMF” at https://www.imf.org/en/Publications/Departmental-Papers-Policy-Papers/Issues/2020/01/31/Stress-Testing-at-the-IMF-48825.