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© 2011 International Monetary Fund

January 2011

IMF Country Report No. 11/4

Guernsey: Financial Sector Assessment Program Update—Technical Note on Stress Testing: Banking and Insurance

This Technical Note on Stress Testing: Banking and Insurance on Guernsey was prepared by a staff team of the International Monetary Fund as background documentation for the periodic consultation with the member country. It is based on the information available at the time it was completed in December, 2010. The views expressed in this document are those of the staff team and do not necessarily reflect the views of the government of Guernsey or the Executive Board of the IMF.

The policy of publication of staff reports and other documents by the IMF allows for the deletion of market-sensitive information.

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Washington, D.C.

Front Matter Page

Financial Sector Assessment Program Update

Guernsey

Stress Testing: Banking And Insurance

Technical Note

December 2010

International Monetary Fund

Monetary And Capital Markets Department

Contents

• Glossary

• Executive Summary

• I. Introduction

• II. Banking Sector

  1. Coverage

  2. Method

  3. Metrics and Calibration of Shocks

  4. Results of Solvency Tests

  5. Results of Liquidity Risk Tests

• III. Insurance Sector

  1. Coverage

  2. Method

  3. Metrics and Calibration of Shocks

  4. Results

• Tables

• 1. Financial Soundness Indicators for the Banking Sector

• 2. Balance Sheet of Banking System, end 2009

• 3. Financial System Structure, 2003-09, by Sector

• 4. Stress Test Results for the Banks

• 5. Scenario Analysis for Banks

• 6. Additional Solvency Tests for Credit Risk

• 7. Liquidity Stress Test for Banks

• 8. Insurance Sector Indicators

• 9. Stress Test Results for the Insurance Sector (end 2009 Data)

• Boxes

• 1. Market Risk Shocks

• 2. Credit Risk Shocks

• 3. Tests Assessing Credit Concentration Risk

• 4. Tests Assessing operational Risk

• 5. Additional TD Tests for Credit Risk

• 6. Liquidity Risk Shocks

• 7. Additional Tests Run for the Insurance Sector

Glossary

Executive Summary

The purpose of stress testing was to assess vulnerabilities in the Guernsey banking and insurance sectors. The approach taken was a simulation of the effect of a potential double dip recession on the solvency of Guernsey banks and insurance companies. The stress tests (ST) were carried out in a manner consistent with those applied in Financial Sector Assessment Program (FSAP) Updates undertaken for the other two Crown Dependencies in 2008, but they also reflected actual experience of institutions and markets in the financial crisis. Hence, in practice, the Guernsey tests were slightly more conservative than in the other Crown Dependencies. As a result of the recovery in capital adequacy since the peak of the crisis (by end 2008), the stress tests were applied against the background of relatively high levels of capitalization at financial institutions (i.e., bank capital adequacy ratios (CARs) at around 19 percent, up from 15 percent at end 2008).

Stress tests for the Guernsey banks:

• Method: The tests comprised both bottom-up (BU) STs (based on STs run by Guernsey banks) and top-down (TD) STs carried out by the mission in collaboration with the Guernsey Financial Services Commission (GFSC).

• Sensitivity Analysis: The Guernsey banks are most vulnerable with respect to credit risk (resulting from parent exposure and large exposures) as well as foreign exchange (FX) rate risk.

• Scenario Analysis: Three banks would need recapitalization in case of a severe macroeconomic shock (e.g., a double dip scenario). Appropriate pro active measures should be taken to reduce risk as deemed appropriate.

• Liquidity Risk: The Guernsey banks are vulnerable if daily withdrawals of all deposits (with a maturity of up to one month) exceed 15 percent per day (relative to the remaining balance) for 5 days (i.e., 56 percent in cumulative terms).

• Conclusions and recommendations: (i) The banking sector is relatively robust (due to the high level of capitalization), but prudence is still warranted due to the vulnerability to low frequency/high impact events; (ii) future STs should be risk-based (i.e., Risk-Weighted Assets should be calculated based on Value-at-Risk methods); (iii) off-site data to run TD stress tests have to be improved, especially to monitor large exposures; (iv) macro-prudential analysis (including STs) should be run by the authorities on a regular basis; (v) in putting in place measures (ii) to (iv), the authorities should consider the appropriate supervisory response to the risks faced by banks in a pro-active manner.

Stress tests for Guernsey insurers:

• Method: BU STs were run based on the outcome of standardized STs carried out by all relevant Guernsey insurers (i.e., those of systemic importance and/or with the riskiest balance sheet structures).

• Sensitivity Analysis: The tests revealed that Guernsey insurers are most vulnerable to changes in interest rates and asset prices. Operational risk is also significant, although this was not explicitly tested for (but is reflected in the outcome of economic capital calculations done by the Guernsey insurers).

• Scenario Analysis: Up to three Guernsey insurers could be adversely affected if a severe macroeconomic shock (double dip) were to materialize. As with banks, appropriate pro-active measures should be taken to reduce risk.

• Conclusions and recommendations: (i) The Guernsey insurance sector appears relatively robust due to a high level of capitalization, but extreme shocks could trigger stress and contagion; (ii) future STs should be risk-based (i.e. capital requirements should be based on economic measures rather than statutory ones); (iii) data to run on- and off-site STs should be improved as a high priority; and (iv) insurers should be encouraged to further develop internal STs and (pro-active) risk mitigation measures should be applied by the GFSC as deemed appropriate.