Front Matter Page

© 2012 International Monetary Fund

July 2012

IMF Country Report No. 12/74

Czech Republic: Technical Note on Stress Testing the Banking Sector

This paper was prepared based on the information available at the time it was completed in July 2012. The views expressed in this document are those of the staff team and do not necessarily reflect the views of the government of Czech Republic 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

Czech Republic

Stress Testing the Banking Sector

Technical Note

July 2012

International Monetary Fund

Monetary and Financial Systems Department

Contents

• Glossary

• Executive Summary

• I. Introduction

• II. Bank Solvency Stress Tests

  • A. Approaches and Coverage

  • B. Scenarios and Shocks

  • C. Concept and Assumptions

  • D. Outcome of the Solvency Tests

• III. Liquidity Stress Tests

  • A. Method and Scenarios

• IV. Stress Tests for Nonbanks

  • A. Insurance and Pension Sector

  • B. Credit Unions

• V. Conclusion and Recommendations

• VI. References

• Tables

• 1. Comparison of Different Solvency Stress Test Methods

• 2. Overview of the Modeling of Key Solvency Parameters

• 3. Overview of the Basel III Minimum Capital Requirements

• 4. Scenarios used for Liquidity Tests

• Figures

• 1. Financial Soundness Indicators for the Czech Banking System

• 2. Overview of the FSAP Bank Stress Testing Framework

• 3. GDP Trajectories Under Different Scenarios

• 4. Potential Impact of Pillar 2 Capital Charges for Name Concentration

• 5. Outcome of Solvency Stress Tests for the Czech Banking System

• 6. Distribution of the Outcome of Solvency Stress Tests

• 7. Outcome of Liquidity Stress Tests for the Czech Banking System

• 8. Simplified Stress Test for an Average Credit Union

• 9. Decomposition of Czech Banks’ Operating Income

• 10. Schematic Overview for the Calibration of Funding Costs

• Appendixes

• I. Stress Test Matrix: Solvency Risk and Scenarios

• II. Projections of the Key Stress Test Drivers

• III. Stress Test Matrix for Solvency

• IV. Stress Test Matrix for Liquidity Risk

• Appendix Tables

• I. Evolution of Macroeconomic Variables Under Different Scenarios

• II. Comparison of the Trajectories of Key Risk Drivers by Method

• III. Calibration of Funding Costs used for the FSAP

Glossary

Executive Summary

This note summarizes the stress tests undertaken for the Czech banking system as part of the Financial Sector Assessment Program (FSAP) Update. The tests were tailored to capture the specificities of the Czech banking system, characterized by a high share of foreign-owned banks. It also addressed current market developments and medium-term structural trends. The stress tests were undertaken in close cooperation with the Czech National Bank (CNB), using supervisory data, based on bottom-up tests (BU), and top-down tests (TD) run by the CNB (TD CNB) and the IMF mission (TD IMF).

All banks were assessed against solvency, liquidity, and contagion risks.¹ Solvency tests for the Czech banking system assessed potential vulnerabilities under three adverse macroeconomic scenarios as well as baseline conditions. 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 in terms of profit retention and credit growth. The liquidity tests simulated banks’ resilience against a sudden withdrawal of funding sources. Banks’ maturity mismatch was assessed in follow-up analysis. Contagion risk was analyzed by simulating a partial loss of exposure to parents.

The Czech banking system faces two potential challenges: the impact from a severe macroeconomic downturn and weaknesses at the parent level. The system could be directly affected by the sovereign debt crisis (through the parent banks) or indirectly (through adverse macroeconomic growth scenario in their main trade partner economies), and the two channels are likely to occur simultaneously.

The solvency tests revealed that the Czech banking system is robust even against substantial shocks on a standalone basis, but that contagion risk from parents could render the system slightly undercapitalized. Measured against current and future supervisory standards (i.e., Basel II/III), Czech banks are, with few exceptions, sufficiently capitalized to withstand substantial levels of stress, and are shielded against their main risk, credit losses, thanks to their favorable income position, providing banks with a considerable first line of defense. In addition, Czech banks’ direct exposure to the riskiest sovereign debt exposures in the Euro Area and outside the country more generally is quite limited, except for sizeable exposures to their parents, which are themselves more exposed to sovereign risks.

The liquidity stress tests found that the vast majority of banks are able to cope with large liquidity shocks, and will also meet Basel III standards. The Czech banks are funded mainly by local deposits, which ensures ample liquidity and makes them in a position to transfer part of their liquidity to their parents, subject to a regulatory limit.

Structural changes could reduce banks’ profitability, and could amplify stress conditions in the medium/long term. Profitability could be reduced due to higher competition (a) as a result of fiercer competition for stable funding sources, and/or (b) the entry of new players due to the favorable risk-return ratios enjoyed by the Czech banks in international terms. In terms of financial stability, in addition to a potential reduction in lending margins over time (reducing banks’ first defense line against losses and their capacity to build buffers), banks could attempt to counterbalance such a trend by lower lending standards. Structural tendencies should be taken into account in future stress tests, especially if the forecast horizon is extended beyond two to three years, which could inform macroprudential policies.

The resilience of the nonbank financial sector is mixed, but the impact is unlikely to be systemic. The resilience of the credit union sector has been assessed based on simplified stress tests, indicating that even slightly less favorable conditions as under the baseline could be challenging for about half of the credit unions. For the insurance sector, stress tests conducted by the CNB indicate substantial resilience of the system, also thanks to their high profitability. The latter is supported by separate analysis that reveal that the system is well capitalized in economic terms (i.e., under Solvency II). Future stress tests for the insurance and pension sectors should focus on longer-term vulnerabilities such as the potential impact of persistent low interest rates, assessing interest rate risk on both sides of the balance sheet, and be refined further on the liability side.