Front Matter

Front Matter Page

© 2011 International Monetary Fund

December 2011

IMF Country Report No. 11/371

Germany: Technical Note on Stress Testing

This Technical Note on Stress Testing 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 on July 29, 2011. The views expressed in this document are those of the staff team and do not necessarily reflect the views of the government of Germany 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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Front Matter Page

Financial Sector Assessment Program Update

Germany

Stress Testing

Technical Note

July 2011

International Monetary Fund

Monetary and Capital Markets Department

Contents

  • Glossary

  • Executive Summary

  • I. Solvency Stress Tests

    • A. Overview

    • B. Macroeconomic Scenario

    • C. Satellite Models

    • D. Other Elements of Stress Tests

    • E. Balance Sheet-Based Solvency Tests

    • F. Market-based (Systemic) Solvency Test

  • II. Liquidity Tests for Bank

  • III. Stress Tests Carried out by the German Authorities

  • IV. References

  • Tables

  • 1. Macroeconomic Variables under the Scenarios used for the Solvency Tests

  • 2. Overview of Other Assumptions used for the Solvency Tests

  • 3. Liquidity Test: Overview of Assumptions

  • 4. Pay-out Ratio Conditional on Capitalization under Stress

  • 5. Overview on the Basel III Minimum Capital Requirements

  • 6. Haircuts on Debt Holdings for Core Tests

  • 7. Overview of Outcome of Core Solvency Tests by Banking Group

  • 8. Sensitivity Analysis for Small Private Banks

  • 9. Individual Contributions of Large Banks to Systemic Risk from Market-Implied Expected Losses

  • 10. Fair Value Insurance Premium for Individual Contributions of Large Banks to Systemic Risk

  • 11. Specification of the Liquidity Tests

  • Figures

  • 1. Credit Growth Conditional on Tier 1 Ratio

  • 2. Outcome of Core Solvency Tests—Dispersion by Bank Group

  • 3. Projected Bank ROC and Dividend Payout Yield

  • 4. Supplementary Tests for the Large Banks

  • 5. Market-Implied Historical Contingent Liabilities of Large Commercial Banks

  • 6. Forecast Market-Implied Expected Losses

  • 7. Liquidity Stress Test Results

  • 8. Proxies for LCR and NSFR

  • Box

  • 1. Estimation of the Empirical SPD

  • Appendixes

  • I. Risk Assessment Matrix

  • II. Satellite Models

  • III. Treatment of Fixed-Income Securities

  • IV. The Contingent Claims Analysis Approach—Standard Definition

  • V. Heuristic Approximation of Contingent Liabilities from the Financial Sector

  • VI. The Systemic CCA Methodology—Calculating the Systemic Worst-Case Scenario Using Multivariate Generalized Extreme Value

Glossary

BCBS

Basel Committee on Banking Supervision

bp

Basis point

CEBS

Committee for European Banking Supervision

CCA

Contingent claims analysis

CDS

Credit default swap

ECB

European Central Bank

ES

Expected shortfall

EU

European Union

ICAAP

Internal Capital Adequacy Assessment Process

IMF

International Monetary Fund

IRB

Internal Ratings-Based

LCR

Liquidity Coverage Ratio

LRS

Linear Combinations of Ratios of Spacings

MGEV

Multivariate extreme value

NiGEM

National Institute of Global Econometric Model

NSFR

Net Stable Funding Ratio

PD

Probability of default

PP

Percentage point

QIS

Quantitative Impact Study

RNDP

Risk neutral default probabilities

ROC

Regulatory capital

ROE

Return on Equity

ROC

Return on Capital

RWA

Risk-Weighted Assets

SPD

State price density

UK

United Kingdom

US

United States

VaR

Value-at-Risk

WEO

World Economic Outlook

YTM

Yield-to-maturity

Executive Summary

This note summarizes the stress tests undertaken for the German banking system as part of the Financial Sector Assessment Program (FSAP) Update. Solvency tests for the German banking system assessed medium-term vulnerabilities under two adverse macroeconomic scenarios. The tests considered a variety of measures of soundness, and took into account funding costs, sovereign risk, upcoming changes in the regulatory rules, and behavioral changes of banks. The liquidity tests simulated a sudden withdrawal of funding sources, and the maturity mismatch of banks. Tables 13 provide an overview of the key elements of the stress tests. Both the solvency and liquidity stress tests were undertaken in close cooperation with the authorities, and using a framework that facilitates comparison with peer countries.

The solvency stress tests simulated the impact of a double-dip recession scenario (with a spike in short-term interest rates) and a slow growth scenario on the solvency of the vast majority of the German banking system for the period from 2011–2015. The analysis was based on (i) a bank-by-bank balance sheet approach; and (ii) a market-based system-wide (or systemic) approach. The two methods complement each other, allowing for a comprehensive coverage of the German banking system on the one hand, and the incorporation of spillover effects/contagion on the other. Supplementary analysis based on publicly available data sought to shed light on other potential sources of vulnerabilities, namely the effect of (a) more severe macroeconomic shock scenarios; (b) higher hurdle rates and/or testing against core Tier 1 capitalization; and (c) stress resulting from marking-to-market all peripheral debt securities held by banks.

The liquidity tests were top-down tests to assess potential vulnerabilities to short-term and, to some extent, also to medium-term liquidity shocks; (i) a reverse test to determine the relative vulnerability of different banking groups to losses of funding based on supervisory data; and (ii) the computation of proxies for the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR) for the majority of German banks based on publicly available data.

The test results revealed that German banks are robust against many shocks, but also that important vulnerabilities remain. Measured against current and future supervisory standards, German banks would need limited amounts of additional capital even under the adverse scenarios, with some exceptions if measured against core Tier 1 capitalization.1 Nevertheless, some banks suffer from balance sheet fragilities, and widespread low profitability will make it challenging for many to raise the level and quality of their capitalization, as required under the new Basel III regime and by tougher market conditions. Part of the small private banks will face challenges ahead and more consolidation can be expected in the Sparkassen and cooperative sectors. Although exposures abroad in aggregate are well diversified, particular institutions have more concentrated and potentially worrisome exposures, including to vulnerable European countries. Moreover, some institutions such as certain Landesbanken are especially exposed to a spike in funding costs. The analysis also suggests that larger banks and some private banks are vulnerable to liquidity risk owing to their heavy reliance on wholesale funding.

The larger banks are more susceptible to funding cost risk, which could be a challenge going forward. Given persisting uncertainties in funding markets, it is possible that banks with relatively low levels of capital will experience a sharp increase in funding costs, making it more difficult to recover even if the economic environment improves. However, the relatively strong fiscal stance of Germany has, so far, mitigated funding problems. Furthermore, certain large banks display a greater reliance on volatile income components, such as trading income, and cross-border activities.

Despite the resilience of bank solvency, the secular effects of low profitability are pervasive. Across pillars, low profitability implies that most banks would earn only low returns on equity (ROE)—and would thus be constrained in paying out dividends to attract capital—even in a relatively benign macroeconomic environment. Factors that reduce profitability, such as a flat or inverted yield curve, amplify these effects.2

These results appear broadly similar when tested for sensitivity. Basel III effects (such as adjustments to risk-weights) add to potential strains, but do not appear to be key potential triggers of distress given the long transition periods unless markets anticipate the rules.3 If one includes stress on sovereign debt holdings in the banking book as well as bank debt securities (using publicly available data4), uses hurdle rates higher than the regulatory minimum to anticipate Basel III effects (e.g., 2 percentage points (PPs) more), and accounts for potential even more severe macroeconomic stress, capital needs would of course be more substantial, but not unmanageable for the system as a whole. Capital needs based on the core Tier 1 ratios appear higher, suggesting that banks should intensify efforts to further improve the quality of their capital.

Results obtained using a market-based, systemic approach corroborate those presented above, and suggest that general vulnerabilities to the banking sector have eased from recent highs, although systemic tail risk remains. A very small number of banks generate the bulk of systemic effects, which have increased sharply at the onset of the credit crisis and have spilled over to the rest of the banking sector. The magnitudes of the estimated contribution to systemic risk of the largest German banks is comparable to that estimated for large United States (US) banks in the recent U.S. FSAP, but rather smaller than that for large United Kingdom (UK) banks; thus, results are plausible given differences in the degree of concentration. Large banks still pose significant tail risk to the system, albeit at lower levels than observed during the height of the credit crisis.

The liquidity stress tests found that most banks are able to cope with large liquidity shocks. The large banks and various private banks exhibit some vulnerability toward a sudden withdrawal of wholesale funding, which is also reflected in a less stable funding profile for longer maturities. Smaller German banks and especially the Sparkassen and cooperative banks benefit from their broad deposit base. Due to limitations on the availability of data, it was not possible to consider liquidity positions (or risk to funding costs) by currency.

Germany: Technical Note on Stress Testing
Author: International Monetary Fund