Belgium
Technical Note on Stress Testing the Banking and Insurance Sectors

The Belgium Financial Sector Assessment Program (FSAP) stress testing exercise examines a financial sector that remains in a state of transformation. Domestic economic challenges remain sources of continued uncertainty as the banking sector consolidates and reduces funding risks. Insurers face challenges from adverse economic and business conditions. Solvency and funding shocks under different macroeconomic scenarios were assessed. Both banking and insurance tests underscore the importance of sovereign risk for financial stability. The implementation of stress tests needs to be closely aligned with the resolution and recovery planning.

Abstract

The Belgium Financial Sector Assessment Program (FSAP) stress testing exercise examines a financial sector that remains in a state of transformation. Domestic economic challenges remain sources of continued uncertainty as the banking sector consolidates and reduces funding risks. Insurers face challenges from adverse economic and business conditions. Solvency and funding shocks under different macroeconomic scenarios were assessed. Both banking and insurance tests underscore the importance of sovereign risk for financial stability. The implementation of stress tests needs to be closely aligned with the resolution and recovery planning.

Introduction1

1. This note presents the results of a comprehensive vulnerability analysis of the macro-financial conditions affecting the banking and insurance sectors in Belgium. The document follows a multi-pronged approach, reflecting a critical assessment of a large variety of possible vulnerabilities that can affect individual and system-wide risks in both sectors. The findings are to be used flexibly, given the forward-looking perspective and the objective of identifying emerging vulnerabilities under extreme but plausible stress scenarios. The completion and reporting of findings have been closely coordinated with National Bank of Belgium (NBB).

2. The Belgium FSAP stress testing exercise examines a financial sector that remains in a state of transformation. The crisis set the stage for major restructuring of the financial sector, whereby major banks shed investment banking and asset management activities and shifted focus to a more “traditional” banking model, focused primarily on the domestic market. The top three banking groups were hit hard after massive losses on structured financial products, large write-offs, and provisions forced them to raise capital, reduce their balance sheets, and appeal to the state for capital infusions. The Belgian state provided extensive funding and asset guarantees. Public sector support was also extended to several insurers to maintain the stability of the sector given the systemic relevance of conglomerate structures.

3. The banking system is concentrated with four dominant banking groups representing almost three quarters of consolidated system assets (Figure 1). Assets of foreign-owned banks account for more than half of the sector. The deleveraging in the wake of the financial crisis significantly reduced the size of the banking sector to 310 percent of GDP in mid-2012, with a second wave of deleveraging currently under way, albeit at a slower pace.

Figure 1.
Figure 1.

Belgium Banking Sector Developments

Citation: IMF Staff Country Reports 2013, 137; 10.5089/9781484381069.002.A001

Source: National Bank of Belgium and IMF staff calculations.1The LLP-to-NPL ratio denotes the stock of loan loss provisions (LLPs) as a percentage of non-performing loans (NPLs). The amount of risk-weighted assets (RWAs) is shown as a percentage of total assets. Leverage is defined as the ratio of total assets to CET1 (multiple). All values are calculated as an average for Belgium’s six largest banks, weighted by the relative size of their loan book.2NFC and household deposits and loans corrected for the securitization.3Corrected for the securitization.

4. The insurance sector is embedded in the predominant bancassurance model and dominated by a few conglomerates. It is relatively small compared to the banking sector, accounting for one fifth of the assets held by banks at end-2011. The top five life insurers account for about three quarters of total assets, while the top five nonlife insurers hold some 60 percent. The industry is dominated by composite insurers that conduct both life and nonlife insurance operations.

5. Domestic economic challenges remain sources of continued uncertainty as the banking sector consolidates and reduces funding risks. While aggregate capitalization of the sector compares favorably to other major international banking systems, profitability remains low.2 Despite the stabilization of business margins during the financial crisis and a significant decline of structural costs, further efficiency gains might be difficult to achieve due to the natural wage drift.3 In addition, interest margins are likely to come under pressure in response to lower investment returns, greater use of more costly term deposits and longer-maturity retail bonds (in lieu of wholesale funding), and limited pricing power in an increasingly saturated lending market. Weaker earnings capacity will constrain the banks’ ability to maintain existing capital buffers under the forthcoming new capital requirements and replenish capital in case of renewed macro-financial shocks.

6. Several insurers face challenges from adverse economic and business conditions. The industry’s solvency position has not recovered since the financial crisis. Life insurers have significant liabilities in the form of guaranteed high returns from past policies and have been gradually shifting towards offering contracts with lower guarantees, which increased the risk of surrenders by policyholders.4 Underwriting premiums (although rising) have not been able to offset the negative impact of low interest rates on investment income, which has resulted in below average profitability. The demand for life policies has been eroded by households’ stronger preference for liquidity in recent years and reinforced by a different tax treatment. Nonlife insurers have taken measures to improve their underwriting performance although they remain susceptible to investment risks.

7. Comprehensive and stringent stress tests of the banking and insurance sectors have been conducted in close cooperation with the NBB staff. Both solvency and liquidity stress tests were conducted based on the mid-2012 financial data of the key institutions in the Belgian financial system, as well as the macroeconomic projections and financial market information available at that time. The six largest banks, 36 smaller banks (with a retail and corporate focus), and the six largest insurers were included in the stress tests. The FSAP’s close collaboration with the authorities, banks, and insurance companies meant that granular supervisory information as well as firms’ own internal data were used in the tests, in addition to publicly available information.

8. The objective of the bank stress test exercise was to assess the solvency and funding shocks under different macroeconomic scenarios. The stress test considers the sector’s vulnerability to a renewed economic contraction, including a substantial rise in unemployment, a depreciation of real estate prices, and declining profitability from lending due to competitive pressures on lending rates and rising funding pressures. Also the impact of general conditions affecting risk factors, such as rising sovereign risk and upcoming regulatory reforms, as well as the behavioral changes of banks are examined (together with the impact of the ongoing re-structuring plans).

9. Rising capital levels have enhanced banks’ resilience but some capital shortfall might materialize if the economy does not recover as expected. The results confirm the appropriateness of the supervisory focus on the timely increase of capital buffers, with support measures focused on the restructuring and/or integration of the weaker banks, with dominant foreign ownership in some banks. While most of the large banks exhibit solid capital buffers, several banks are likely to experience a significant deterioration of profitability under certain scenarios which could result in some capital shortfall over the forecast horizon. Credit risk appears generally limited, with historically low loss rates, but potential vulnerabilities from real estate overvaluation warrant deeper supervisory follow-up. Moreover, uncertainty about hard-to value portfolios (most of which comprise legacy assets from a reduction of activities abroad) is a downside risk affecting banks’ internal projections of future performance under stress.

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Belgium—Macroprudential Stress Tests of Banking Sector

Citation: IMF Staff Country Reports 2013, 137; 10.5089/9781484381069.002.A001

10. Liquidity and funding risks have abated for the time being. Funding structures have become more favorable overall. Stricter liquidity regulation by the NBB introduced in 2011 has been conducive to greater focus on liquidity risk management. The European Central Bank’s longer-term refinancing operation program has removed intermittent funding problems during the height of the European sovereign debt crisis and remains an important backstop for the sector. However, banks have reduced the amount of outstanding wholesale funding, but remain dependent on market-sensitive nonbank institutional and corporate deposits, which amount to about one third of the deposit base. Nonetheless, asset encumbrance is relatively high, with total unencumbered liquid assets having declined relative to the amount of short-term liabilities. In absence of greater diversity of funding sources with longer maturity tenors, greater reliance on deposit funding will, however, perpetuate the high level of sovereign debt and other liquid assets as liquidity buffers.

11. The insurance stress test assessed the capital adequacy of the sector under the impact of different shocks to both investment and underwriting performance. The stress test comprises single factor shocks to a selected set of risk drivers that are directly inferred—or reasonably sensitive—to the general economic scenarios examined in the banking sector stress test. Also the impact of general conditions affecting risk factors, such as rising sovereign risk and upcoming regulatory reforms are examined as the sector transitions from the current Solvency I regime to a more risk-based and market-consistent solvency standard (Solvency II).

12. Insurers’ capital levels are sufficient under the current regulatory regime but pressure points have emerged. While a few insurers exhibit sufficient capital buffers, most firms are likely to show a significant decline in solvency ratios under a full “market-consistent valuation” (MCV) approach.5 Generally low investment returns have compounded several other steadily building pressures on nontechnical income, which compressed profit margins and is likely to limit the sector’s claims-paying capacity over the medium term. Insurers also face liquidity risks. A weakening of confidence can increase early surrenders of policies, especially given the low penalty rate. Also liquidity management via intragroup transactions in conglomerates through liquidity transformation may underestimate the liquidity needs of insurers in the longer term.

13. Both banking and insurance tests underscore the importance of sovereign risk for financial stability. The wholesale funding access of banks is likely to remain vulnerable to changes in market’s perception of sovereign risk.

14. This Technical Note is structured as follows. The next section, Banking—Solvency Stress Tests, presents the different components of the FSAP’s solvency stress test of the banking sector, analyzes the results of the bottom-up (BU) test, and cross-validates the findings of the corresponding top-down (TD) test results. The findings of the liquidity stress testing exercise are covered in the third section, Banking—Liquidity Stress Tests, followed by a summary of important findings for further work in this area. It is followed by the analysis of the insurance stress test in the fourth section, Insurance—Solvency Stress Tests. The fifth section presents important policy implications of these findings. The final section concludes.

Banking—Solvency Stress Tests

15. Solvency stress tests based on banks’ mid-2012 unaudited financial results were undertaken in this FSAP exercise. The objective was to determine the capacity of the banking sector to absorb realization of key macro-financial risks, which would result in downside deviations from a defined baseline scenario. The stress tests were based on economic and market conditions as of mid-2012, the cut-off date of the exercise, and did not take into account developments in the international capital markets during the completion of the exercise.

16. Two-pronged approach to solvency stress testing covered more than 93 and 91 percent of the domestic banking sector on a solo and consolidated basis, respectively, and comprises (Tables 1 and 2):

Table 1.

Stress Test Matrix (STeM) for the Banking Sector: Solvency and Liquidity Risks

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Table 2.

Composition of the System and Banks Included in the Stress Tests

(As of mid-2012, EUR millions)

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  • A bottom-up (BU), balance sheet stress tests conducted by the six largest banks (“Group 1”) in collaboration with the FSAP team and NBB staff based on consolidated data, following the calculation method and guidelines provided by the FSAP team.6

  • A cross-validation of results by a top-down (TD), balance sheet stress test based on solo data on the FSAP team’s assumptions, in collaboration with NBB staff.7 This part of the exercise involved “Group 1” banks and 36 smaller banks, which were grouped into three different groups (“Group 2”: 19 small retail banks, “Group 3”: 7 small retail banks, and “Group 4”: 10 small private banks).8

17. Two adverse macro scenarios were used, a severe and short-term “double-dip recession” and a protracted slow growth environment (“slow growth scenario”). The first scenario comprises two standard deviations of long-term real GDP growth from the IMF-projected baseline growth trend over the first two years with a positive adjustment dynamics during the subsequent three years of a five-year forecast horizon (Table 4 and Figure 5).9 In the slow growth scenario, a similar cumulative deviation from the baseline is distributed over the forecast horizon as a result of continued shocks to demand amid rising inflation expectations. The severity of these shocks is consistent with other stress testing exercises in the European country FSAPs.

Table 3.

Financial Soundness Indicators for Banks Included in the Solvency Stress Test

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Source: NBB and IMF staff calculations.
Table 4.

Macroeconomic Scenarios for Solvency Stress Test

Economic Activity under Different Scenarios

(percentage change from previous period, unless otherwise indicated)

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Source: NBB and IMF staff calculations.
Figure 2.
Figure 2.

Belgium: Liquidity and Short-term Funding

Citation: IMF Staff Country Reports 2013, 137; 10.5089/9781484381069.002.A001

Sources: NBB and IMF staff calculations.Note: All data were derived from a legal entity basis.1/ Unencumbered liquid assets: liquid assets include all unencumbered cash and central bank reserves as well as all unencumbered central bank eligible, repo-eligible, marketable and re-usable financial assets, measured at market value and before prudential haircuts (= buffer stress test ratio before haircuts).2/ Short-term wholesale funding: sum of unsecured open maturity, wholesale deposits and unsecured bonds as well as similar liabilities with a remaining maturity of less than one year; intra-group, secured, long-term (> 1 year) and retail financing is thus not included.3/ Short-term secured wholesale funding: secured funding with residual maturity of less than one year obtained form third parties (i.e., excluding related party repo financing); the sharp decrease in outstanding between September and October 2011 is driven by the fact that one additional large bank attracted a small amount of secured funding, which decreased the median value substantially.4/ Callable whole sale funding: callable wholesale funding includes all unsecured wholesale deposits and bonds with an open maturity or maturing within one week. Intra-group, secured, medium term (> 1 week) and retail financing is thus not included. Total debt includes all unsecured/secured retail and wholesale financing.
Figure 3.
Figure 3.

Belgium: Bank Funding

Citation: IMF Staff Country Reports 2013, 137; 10.5089/9781484381069.002.A001

Source: Dealogic and IMF staff estimates.
Figure 4.
Figure 4.

Belgium: Insurance Financial Soundness Indicators (FSIs)

Citation: IMF Staff Country Reports 2013, 137; 10.5089/9781484381069.002.A001

Source: NBB and IMF staff calculations. Box plots include the mean (red dot) and the 25th and 75th percentiles (grey box, with the change of shade indicating the median). Bar charts in the bottom panel show medians.
Figure 5.
Figure 5.

Belgium: Macroeconomic Assumptions under Different Stress Test Scenarios

Citation: IMF Staff Country Reports 2013, 137; 10.5089/9781484381069.002.A001

Sources: National Bank of Belgium; and IMF staff estimates.

18. Macro projections and guidelines on selected parameters are applied as much as feasible in a consistent manner:

  • Based on the growth scenarios, related key macro and financial variables are projected using IMF staff estimates and the NBB’s macro model (Jeanfils and Burggraeve, 2005) (Figure 5). The inputs to the solvency stress tests consist of real GDP (including private consumption, gross fixed capital formation, imports, exports, and inventories), household savings and unemployment rate, price and cost developments (consumption prices, house prices, commercial real estate prices, equity market index, GDP deflator, unit labor cost, and terms of trade), and interest rates (short-term interest rate and 10-year sovereign bond yield).

  • Both TD and BU exercises include prescriptive assumptions covering areas such as risk factors (loss rates, profitability, fixed income holdings, exchange rates, taxes, sovereign debt haircuts, and funding costs), behavioral adjustments (balance sheet growth, dividend payout, credit growth, asset disposal, and capital raising), and regulatory changes (capital requirements, risk-weighted assets (RWAs), and definition of capital) (Attachment I).

  • Structural changes to business models and some potential mitigating factors have not been considered within the scope of the exercise. For example, on-going de-risking of balance sheets through restructuring, which is reflected in a gradual decrease of RWAs,10 and de-leveraging through run-offs and divestments have only been included if they were announced/implemented before the cut-off date of the stress test exercise and did not require further managerial intervention. Other mitigating factors, such strategic decisions resulting in changes to financial obligations vis-à-vis third parties over the forecast horizon as well as contingent capital arrangements and bail-in provisions, are not considered.

19. Solvency is assessed in accordance with Basel III standard. The hurdle rates applied in the stress tests follow the internationally agreed schedule for Basel III implementation (Table 5). As the capital conservation buffer will come into full effect only after the end of the stress test horizon, it is relevant for this exercise only in the last two years of the five-year forecast horizon.

Table 5.

Overview of the Basel II and III Minimum Capital Requirements

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Source: Basel Committee for Banking Supervision (BCBS). Note: See BCBS (2010b and 2010c) and Appendix III for capital definitions. According to recent revisions to the liquidity risk framework under Basel III (BCBS, 2013) the introduction of the Liquidity Coverage Ratio (LCR) will be now be graduated. Specifically, the LCR will be introduced as planned on January 1, 2015, but the minimum requirement will begin at 60 percent, rising in equal annual steps of 10 percentage points to reach 100 percent on January 1, 2019.

A. Summary of Both Solvency Stress Tests

20. Results from both BU and TD exercises suggest a significant erosion of the capital base under stress (Figure 6). Given the solid capital buffers in the beginning of stress test, the potential capital shortfall in the sector is limited to EUR 1.6 billion of CET1 until the end of the forecast horizon, which represents 3.6 percent of CET1 in the sector (Figure 10).11 The same macro-financial sensitivity of risk drivers translates into higher reductions of risk-based capitalization for the two alternate hurdle rates of lower-quality capital. The Tier 1 capital ratio declines by 4.4 and 4.5 percentage points for the TD exercise and 4.8 and 4.0 percentage points for the BU exercise under both adverse scenarios, respectively. For the total capital ratio, these values increase to 4.9 and 5.0 percentage points for the TD exercise and 5.5 and 4.7 percentage points for the BU exercise under both adverse scenarios, respectively. Under the BU approach, the aggregate CET1 capital ratio declines by 4.2 and 3.5 percentage points under the double dip and slow growth scenarios, respectively. The findings are similar for the TD exercise, which indicates a decline by 3.7 and 3.9 percentage points, respectively. The different results obtained under the two adverse scenarios in the BU exercise reflect a faster rise of the marginal loss rates under the double-dip scenario while the slow growth scenario allows for a less adverse evolution of net interest margins.

Figure 6.
Figure 6.

Belgium: Solvency Stress Tests—Risk Drivers

Citation: IMF Staff Country Reports 2013, 137; 10.5089/9781484381069.002.A001

Source: NBB and IMF staff estimates. The sample of banks included in the stress test differs between the two approaches. The top-down exercise includes 42 banks on solo basis (Groups 1-4), representing 93 percent of the banking sector (excluding foreign branches), whereas the bottom-up exercise comprises the six largest banks (Group 1) on a consolidated basis, covering 90 percent of the sector.
Figure 7.
Figure 7.

Belgium: Evolution of Aggregate Capital Ratios in Solvency Stress Tests

Citation: IMF Staff Country Reports 2013, 137; 10.5089/9781484381069.002.A001

Source: NBB and IMF staff estimates. The sample of banks included in the stress test differs between the two approaches. The top-down exercise includes 42 banks on solo basis (Groups 1-4), representing 93 percent of the banking sector (excluding foreign branches), whereas the bottom-up exercise comprises the six largest banks (Group 1) on a consolidated basis, covering 90 percent of the sector.
Figure 8.
Figure 8.

Belgium: Solvency Stress Test Results—Total Capital Hurdle Rates

Citation: IMF Staff Country Reports 2013, 137; 10.5089/9781484381069.002.A001

Source: NBB and IMF staff estimates. The sample of banks included in the stress test differs between the two approaches. The top-down exercise includes 42 banks on solo basis (Groups 1-4), representing 93 percent of the banking sector (excluding foreign branches), whereas the bottom-up exercise comprises the six largest banks (Group 1) on a consolidated basis, covering 90 percent of the sector. Box plots include the mean (yellow dot), the 25th and 75th percentiles (grey box, with the change of shade indicating the median), and the 10th and 90th percentiles (whiskers). The red line indicates the Basel III hurdle rate.
Figure 9.
Figure 9.

Belgium: Solvency Stress Test Results—Tier 1 Capital Hurdle Rate

Citation: IMF Staff Country Reports 2013, 137; 10.5089/9781484381069.002.A001

Source: NBB and IMF staff estimates. The sample of banks included in the stress test differs between the two approaches. The top-down exercise includes 42 banks on solo basis (Groups 1-4), representing 93 percent of the banking sector (excluding foreign branches), whereas the bottom-up exercise comprises the six largest banks (Group 1) on a consolidated basis, covering 90 percent of the sector. Box plots include the mean (yellow dot), the 25th and 75th percentiles (grey box, with the change of shade indicating the median), and the 10th and 90th percentiles (whiskers). The red line indicates the Basel III hurdle rate.
Figure 10.
Figure 10.

Belgium: Solvency Stress Test Results—CET1 Capital Hurdle Rate

Citation: IMF Staff Country Reports 2013, 137; 10.5089/9781484381069.002.A001

Source: NBB and IMF staff estimates. The sample of banks included in the stress test differs between the two approaches. The top-down exercise includes 42 banks on solo basis (Groups 1-4), representing 93 percent of the banking sector (excluding foreign branches), whereas the bottom-up exercise comprises the six largest banks (Group 1) on a consolidated basis, covering 90 percent of the sector. Box plots include the mean (yellow dot), the 25th and 75th percentiles (grey box, with the change of shade indicating the median), and the 10th and 90th percentiles (whiskers). The red line indicates the Basel III hurdle rate.

21. The results are heavily influenced by more stringent capital requirements and the diminished earnings capacity of the sector if economic conditions were to deteriorate. Increasing provisions for credit risk and higher loan impairments, valuation losses from rising sovereign risk, and the impact of regulatory changes on both RWAs and capital are the main risk drivers, whose impact on solvency is currently mitigated by robust credit conditions and significant deleveraging of the sector (Figure 6). RWAs increase by 10.3 percent over the stress test horizon under each scenario suggests that the transition to Basel III provides incentives for further de-risking of balance sheets, a process that is continuing at present. Credit risk is currently limited due to low marginal loss rates in the sector, but nonperforming loan balances in the real estate sector rise considerably in relative terms under stress. The flattening of the sovereign yield curve diminishes the benefits of cost-effective deposit funding as net interest margins are likely to decline due to the indexation of domestic variable-rate loan mortgages on Belgian government bonds and lower investment yields.12 However, insufficient profitability limits further build-up of capital buffers, especially after the full adoption of the forthcoming new capital requirements. Some larger banks in the system appear more affected even under baseline conditions, possibly owing to uncertainty about valuation of legacy assets and increased lending competition.

22. In particular, sovereign risk affecting nonbanking income is material and heavily affects overall results in both BU and TD exercises. Market-implied valuation haircuts of more than five percent on the debt securities issued by the Belgian government (and more than 10 percent for securities issued by vulnerable European sovereigns; Attachment I) have been applied to all direct and indirect (via derivatives positions) exposures at mid-2012 prices. These haircuts to capital buffers reduce CET1 capital in the system by more than EUR 4.6 billion (or 10.4 percent) under the adverse scenarios. The aggregate effect of escalating sovereign risk was more pronounced in the TD exercise, and contributed more than half of the estimated decline of net income due to trading and valuation losses under both adverse scenarios.13 However, the sovereign risk of main debtor countries (including that of the local government) has in fact decreased since mid-2012, which would reduce the estimated valuation haircuts. In addition, this would reduce the need to build available for sale (AfS) reserves, whose mitigating effect is not considered in the stress tests.

B. Bottom-Up Solvency Stress Tests

23. The BU stress tests involving the six major banks formed the core element of the solvency risk assessment. The exercise was administered jointly with the NBB, with banks conducting the stress tests using their own internal models. Detailed guidelines on assumptions were drawn up by the FSAP team in collaboration with the NBB and in consultation with the banks themselves (Attachment I). These guidelines contain key assumptions relating to the calibration and estimation of important risk drivers, which are necessary to ensure a robust and credible assessment of system-wide capital adequacy during times of stress.

24. Each bank submitted a “report card” of the outcome to the NBB, which provided them to the FSAP team for further analysis. For each bank, the analysis estimates changes in potential losses from asset impairments, profitability, regulatory impact of Basel III on the definition of capital as well as post-shock RWAs and, where applicable, the capital needs (Attachment I).14 The team also met with the risk management and stress testing teams from each bank to discuss in detail the stress test design and results.

25. The BU stress test results suggest that the largest Belgian banks are resilient to significant economic stress, but at least two institutions are vulnerable in the medium term. Specifically, the findings were:

  • Although five out of six firms pass the capital hurdle rates under all scenarios, two banks experience a substantial impact on capital in the double-dip and slow-growth scenarios. The common Tier 1 ratios diverge by as much as 4.5 percentage points from their pre-stress capitalization.

  • Both adverse scenarios generated similar results, but the double-dip scenario turned out to be the more stringent. The prolonged slow growth scenario did not have as negative an impact as initially anticipated—an outcome that banks attributed to the relatively benign development of the interest rate scenario. That being said, the likely spread compression in a more competitive market and a gradual increase of impairment balances will challenge their earnings capacity under both adverse scenarios.

  • Since most banks currently hold robust capital positions (with a large share of common equity), the capital impact of economic stress shows towards the end of the five-year forecast period. The weighted-average total capital, Tier 1 and common equity Tier 1 capital ratios for the aggregated sample stay at or above 11.3 percent, 9.6 percent, and 9.0 percent, respectively (under the slow growth scenario), and fall to 10.1 percent, 8.5 percent, and 7.9 percent, respectively (under the double-dip scenario)—but still above the Basel III hurdle rates. However, the leverage ratio for two banks drops below the three percent threshold in the final year of the forecast horizon (under the double-dip scenario) due to increasing negative profitability. Not surprisingly, retail-focused banks with large mortgage loan portfolios would be hardest hit by a sharp economic downturn.

C. Top-Down Solvency Stress Tests

26. A balance sheet-based framework was used to generate stress estimates for assessing the systemic risk and individual capital adequacy of all commercial banks. The approach provided a quantitative assessment of capital adequacy on bank-by-bank basis. Several satellite models were used under each scenario to determine changes in profitability and credit losses using the historical sensitivity of bank performance to macro-financial variables. These macro-financial linkages were estimated based on two-stage least squares panel data regressions over quarterly observations between Q3 1997 and Q1 2012 (using general method of moments with orthogonal deviations; see Arellano and Bond (1991) and Arellano and Bover (1995)) of the profitability components (interest income, interest expenses, fee/commissions income, and operating expenses) as well as the flow of asset impairments (i.e., nonperforming loan balance).15

27. The results from the TD exercise confirm the BU stress test results, but suggest potentially higher capital needs under stress for weaker firms:

  • Two firms fall below the capital hurdle rates under any scenario, with one additional bank experiencing a shortfall of Tier 1 capital in the last year of the forecast horizon under the slow growth scenario.

  • In contrast to the BU exercise, the slow growth scenario turned out to be more severe. Indeed, the impact of prolonged slow growth on all capital components generally appears less benign than that of the double-dip recession and had a more significant impact on the aggregate capitalization of the sector. The weighted-average total capital, Tier 1 and common equity Tier 1 capital ratios for the aggregated sample stay at or above 11.8 percent, 9.2 percent, and 8.6 percent, respectively (under the slow growth scenario), but slightly increase to 11.9 percent, 9.4 percent, and 8.7 percent, respectively (under the double-dip scenario).

  • A sensitivity analysis of the individual capital ratios shows that capitalization of smaller banks is falling very close to the hurdle rates suggesting that these banks would need to build additional capital buffers under the adverse scenarios in order to satisfy market expectations of maintaining a buffer above the regulatory minimum throughout transition schedule to Basel III.

D. Reconciliation of Both Solvency Stress Tests

28. The TD stress test results are broadly consistent with the aggregated BU findings. The trends for core Tier 1, Tier 1, and total capital ratios under both approaches, for the baseline and both adverse scenarios, are similar but show some differences that are driven by the baseline estimates (Figures 7-11). TD results show a greater decrease in capital ratios than the BU outcomes in the baseline scenario, whereas the converse holds true under the adverse scenarios, with differences between both approaches becoming more marked in the latter years of the stress test horizon. The impact of the prolonged slow growth scenario in the TD exercise appears somewhat stronger than the same scenario in the BU exercise. The distribution of individual capital ratios differs somewhat, but the median result is generally consistent for each of the three hurdle rates both approaches.

Figure 11.
Figure 11.

Belgium: Banks’ Liquidity Ratios and Stress Test Results

Citation: IMF Staff Country Reports 2013, 137; 10.5089/9781484381069.002.A001

Source: NBB, EBA, and IMF staff calculations. Box plots include the mean (yellow dot), the 25th and 75th percentiles (grey box, with the change of shade indicating the median), and the 10th and 90th percentiles (whiskers). Ratios are capped at 400 percent, both for the calculation of the averages and in the charts.

29. Differences in the two sets of results are likely attributable in part to the model design and the scope of the stress testing exercise. The aggregate BU results are based on bank’s own approaches, as long as they are consistent with the common principles stated in the BU stress testing guidelines (Attachment I). Firm-specific assumptions and the application of internal models based on more granular data can lead to differences in the projection of profits and losses for individual firms under the various scenarios. For instance, projected net interest income and credit losses account for much of the difference in the impact of the various adverse scenarios on the capital ratios in both TD and BU exercises. It is most obvious in the severe double-dip and the slow growth scenarios for each of the capital ratios. This can be explained by the fact that the uniform sensitivity of changes in nonperforming loan balances for each bank (implied by the panel data estimates) creates less diverse loss results across banks under prolonged stress in the context of the TD exercise. Moreover, differences can also be explained by the fact that the BU tests are undertaken by the six largest banks at the consolidated level whereas the TD analysis is performed on a larger sample (also including smaller banks) on a solo basis.

Banking—Liquidity Stress Tests

30. A suite of liquidity stress tests was carried out by the NBB staff in consultation with the FSAP team based on the NBB liquidity ratio and the standard Basel III measures of liquidity risk. The NBB’s liquidity reporting format was used for this part of stress testing exercise. Similarly to the internal thematic liquidity risk assessment exercise of the 2011 system-wide stress test of the largest European banks conducted by EBA, all liquidity stress tests were completed separately from the solvency risk analysis. Due to the stringency of assumptions that have been applied consistent with other FSAP stress tests, the findings are informative regarding the dynamics of aggregate funding positions under very severe system-wide distress.

31. The liquidity stress tests aimed to capture the risk that a bank fails to generate sufficient funding to satisfy short-term payment obligations due to one or more of the following channels affecting cash flows: (i) scheduled and unscheduled cash outflows; (ii) cash inflows related to maturing assets and assets repo-able or saleable at stressed market values (“market liquidity risk”); (iii) restricted ability to access funding markets (“funding liquidity risk”); and (iv) the ability to survive funding constraints due to the rollover risk stemming from maturity mismatches. In this regard, assumptions about the decline in asset values, amortization/renewal rates, and the extent to which assets were subject to haircuts when used as collateral for wholesale funding influence the severity of cash flow calculations have been made (Tables 6 and 7).

Table 6.

Liquidity Stress Test Parameters

(Basel III Standard Measures)

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Table 7.

Liquidity Stress Test Parameters

(NBB Liquidity Ratio)

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32. Two types of liquidity regimes were examined: (i) the Basel III standard measures of liquidity risk—the Liquidity Coverage Ratio (LCR), in its old and revised definition, and the Net Stable Funding Ratio (NSFR)—for “Group 1” banks only; and (ii) the national liquidity risk framework—the NBB’s liquidity ratios (at one-week/one-month risk horizons)—covering 42 institutions (i.e., “Groups 1-4”). Additional scenarios were applied to the one-month NBB liquidity ratio (Table 8): (i) the absence of a retail deposit run (in order to examine the impact of the large deposit base on the liquidity ratio), (ii) the escalation of sovereign risk (requiring higher valuation haircuts for collateralized funding with major central banks), and (iii) the absence of contingent cash inflows from related parties.

Table 8.

Insurance Sector—Stress Test Specification

(In basis points, unless otherwise specified)

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Source: NBB and EIOPA. Note that the haircuts of the banking stress test (Attachment I, Appendix VII) were applied for stress test of the insurance sector under the current Solvency I regime. For both the MCV and the QIS-5 valuation, the EIOPA specifications of sovereign bond stresses were used in the form of higher sovereign spreads for each country shown above.

33. The Basel III liquidity framework is based on two quantitative liquidity standards that aim to strengthen liquidity risk management practices in banks. Under this proposal, banks are expected to maintain a stable funding structure, reduce maturity transformation, and hold a sufficient stock of assets that should be available to meet its funding needs in times of stress (BCBS, 2010c and 2012b). The framework is based on two standardized ratios:

  • Liquidity Coverage Ratio (LCR)—This ratio is intended to promote short-term resilience to potential liquidity disruptions by requiring banks to hold sufficient high-quality liquid assets to withstand the run-off of liabilities over a stressed 30-day scenario specified by supervisors. LCR requires that banks hold a sufficient stock of unencumbered, high-quality liquid assets to cover cash outflows less cash inflows (subject to a cap at 75 percent of total cash inflows) that are expected to occur during in times of stress. In January 2013, the Basel Committee reached an agreement on a composition of high-quality liquid assets and parameters for net cash outflows resulting from deposits and contingent liabilities, as well as a transition period for introduction of LCR (BCBS, 2012b and 2013). LCR of less than 100 percent indicates a liquidity shortfall.

  • Net Stable Funding Ratio (NSFR)—Final agreement on this structural ratio, which would limit the stock of unstable funding by encouraging longer-term borrowing in order to restrict liquidity mismatches from excessive maturity transformation, has not yet been reached by the Basel Committee. Based on existing proposals, it would require banks to establish a stable funding profile over the short term, i.e., the use of stable (long-term and/or stress-resilient) sources to continuously fund cash flow obligations that arise from lending and investment activities inside a one-year time horizon. The NSFR would reflect the proportion of long-term assets that are funded by stable sources of funding, which includes customer deposits, long-term wholesale funding with maturities of more than one year, and equity (but excludes short-term funding). A value of this ratio of less than 100 percent indicates a shortfall in stable funding (BCBS, 2010c).

34. NBB’s liquidity risk framework consists of one-week and one-month liquidity ratios (“NBB liquidity ratios”). The framework was introduced in 2009 and became binding in 2011 (CBFA, 2010). The NBB liquidity ratio broadly follows LCR’s 30-day risk horizon and rationale but defines the liquidity position after deducting cash inflows from cash outflows (rather than the other way around as in the definition of the LCR) in order to derive net cash outflows (if any) relative to the stock of liquid and unencumbered assets. Thus, an NBB stress test ratio higher than 100 percent implies a liquidity shortage if the stress scenario—implied by the application of suitable funding and market liquidity risks to liquid assets and cash flows—would materialize at the reporting date (i.e., potentially required liquidity greater than potentially available liquidity).

35. Overall, the stringency of the Belgian liquidity standard is consistent with the revised LCR but stems from different assumptions that determine net stressed outflows and the scope of the liquidity buffer. The NBB liquidity ratio is generally less severe with regard to the definition of the liquidity buffer (i.e., the evaluation of high-quality, liquid assets), which is compensated by stricter assumptions on the stress scenario and contingent cash outflows, which shows in a greater sensitivity of banks conducting trading activities. Another difference is the risk-based treatment of available liquidity from sovereign assets in central bank and repo market operations, which receive a zero run-off assumption under the revised LCR as opposed to the NBB ratio, which applies a valuation haircut of up to 30 percent.

36. Most large banks hold sufficient liquidity under the Basel III framework (Figures 2 and 11). The revised definition of the LCR leads to a significant improvement in the banks’ ability to comply with standard measures of liquidity risk. Estimates suggest that applying the new definition of the LCR improves the system-wide ratio to 103 percent, with only one institution below the threshold. Most banks have access to sufficient stable sources of funding due to a large deposit base, with the average NSFR at 112 percent. Even though only four of the six largest banks pass the test, all of them exhibit NFSR ratios higher than 95 percent.16

37. The stress test results using the regulatory liquidity ratios of the national liquidity framework (“NBB Liquidity Ratio”) show that most banks are able to support a severe but short-lived shock to cash flows:

  • All Belgian banks have enough liquid assets to withstand a week-long net cash outflows (on a solo and consolidated basis), with the average inverse NBB liquidity ratio of 263 percent.17 At 220 percent, the ratio for the large banks is only slightly lower than the system-wide average, and well above the required 100 percent.

  • Extending the risk horizon to one month results in some liquidity shortage, which remains concentrated in a very few institutions, with the average ratio still high at 159 percent (141 for Group 1 banks). Results suggest an underlying shortfall (i.e. the difference between net cash outflows and high-quality liquid assets) of EUR 3.9 billion, or 0.5 percent of assets used in the liquidity calculations for the six largest banks. This number is reflective of the aggregate shortfall for banks that are below the 100 percent requirement and does not reflect surplus liquid assets at banks above the 100 percent requirement.

  • The withdrawal of contingent intragroup funding does not change the results markedly. The additional severity of disregarding potential cash inflows from related parties is limited, with the aggregate liquidity shortage in line with the baseline scenario. The liquidity ratio falls to 134 percent for the large banks (120 percent on consolidated basis), with two large banks failing the test on consolidated basis, one of them close to the hurdle rate. However, intragroup funding by larger institutions to their foreign parents remains large—despite the introduction of a 100 percent of own funds limit in 2011—and places a premium on sufficient liquidity buffers at Belgian subsidiaries.

  • Similarly, a liquidity risk from a moderate increase in sovereign risk is very small. A 50-percent increase in haircuts on sovereign bonds eligible for collateralized central bank funding with the ECB/Eurosystem, the Bank of England, or the Swiss National Bank (from 5 percent included in the standard definition of the NBB ratio to 7.5 percent) has only limited impact on banks’ liquidity buffers. Most banks pass the test, with the resulting liquidity ratio of 141 percent (121 percent of consolidated basis).

38. However, the aggregate implications of bank-by-bank prudential measures under the Basel III and national liquidity framework disregard the system-wide perspective. The current approaches assume that sufficient institutional liquidity reduces the likelihood of knock-on effects on solvency conditions in distress situations and complement the risk absorption role of capital—but without considering system-wide effects. This implies that larger liquidity buffers at each bank should lower the risk that multiple institutions will simultaneously face liquidity shortfalls, which would ensure that central banks are asked to perform only as lenders of last resort—and not as lenders of first resort.

39. These liquidity stress test results need to be put into context given their static nature and the assumption that all banks face escalating liquidity risk at the same time. Given the assumptions and modeling technique, any estimated liquidity shortfall should be interpreted in terms of a general vulnerability to the particular set of assumptions, rather than it being representative of an actual liquidity need in a general stress situation. In fact, the calculated effect might overstate the actual impact of assumptions on the actual realization of varying cash flow scenarios. Ideally, the results would be qualified based on mitigating considerations, such as, for example, the likely reallocation of deposits within the banking sector in a situation when not all banks experience funding shocks simultaneously (and assuming that deposits largely remain in the banking system).

Summary and Policy Implications—Banking

40. Overall, the stress test results confirm the importance of continued supervisory commitment towards the maintenance of existing capital and liquidity buffers given the significant feedback loops to sovereign risk. While most banks appear sufficiently capitalized to withstand a further deterioration of economic conditions, there are substantial vulnerabilities to rising sovereign risk impacting both funding and solvency conditions. In fact, the banking-sovereign linkages have intensified and put a premium on sufficient shock absorbers in the system as the capacity of the public sector to provide future financial sector support in times of distress has diminished.

41. The tenuous economic recovery and the impact of impending regulatory changes affect the forward-looking capital assessment of the sector. Belgian banks are subject to the Basel III capital requirements according to the agreed gradual phase-in schedule. The authorities also have the intention to implement the liquidity standards ahead of the phase-in schedule agreed under the revised liquidity risk framework under Basel III. The potential adverse implications of these regulatory changes on risk-based capitalization would need to be carefully balanced as new vulnerabilities are emerging from the transformation of the sector. A weak economic environment and higher unemployment are likely to affect debt servicing capacity and affordability, which might lead to rising asset impairments that would be difficult to offset in more competitive environment reducing profitability due to lower net interest margins over the medium term. Also a price correction of residential and commercial real estate would put further downward pressure on the net operating income of the sector and could significantly increase the estimated capital shortfall on aggregate. Faced with excess liquidity from domestic savings, banks could also be inclined to increase investment yields and intragroup funding arrangements within conglomerate structures.

42. Authorities should use the stress test results for a thematic review of identified vulnerabilities and integrate risk-based supervision into the macroprudential policy and surveillance framework. Supervisory follow-up would be needed to support the current business model review of some banks and encourage greater involvement of supervisors in financial stability analysis. The authorities should carefully assess the impact of further spread compression, interest rate shocks, and the gradual deterioration of credit quality at some banks and expedite the consolidation process to restore confidence in the domestic banking sector. For liquidity risk, the close alignment of the recently revised definition of the LCR and the Belgian liquidity ratio suggest that the current liquidity regime should be preserved (and liquidity buffers be maintained) before the LCR is fully adopted at the European level in 2018.

43. Going forward, the authorities should embed this stress testing approach in the macroprudential policy and surveillance framework. The systematic integration of both TD and BU stress testing into the supervisory framework will help inform the assessment of the financial soundness of individual firms under different scenarios and encourage greater involvement of supervisors in financial stability analysis. Even though the stress tests comprehensively cover the most salient risk drivers, other sources of vulnerability require more granular prudential information, e.g., intragroup transactions within conglomerates under severe stress conditions. This would allow stress testing to become a routine tool for micro- and macroprudential surveillance. Finally, greater awareness on the flexible use of stress testing could also support self-assessment as part of the current peer review on macroprudential supervision among euro area members.

Insurance—Solvency Stress Tests

44. Stress testing of insurer solvency was undertaken as a bottom-up exercise to determine the capacity of the sector to absorb a combination of single factor shocks affecting each capital component. The stress test covered the six largest insurers, comprising more than 70 percent of the insurance sector, and was conducted by insurers themselves in collaboration with the FSAP team and NBB staff based on mid-2012 prudential data, following the calculation method and guidelines provided by the NBB.18,19 In the insurance sector, macro-financial linkages often vary by different business lines as well as technical factors influencing the pricing and reserving of insurance products. In general, the most significant association of the insurance cycle with changes in economic growth can be found in forward-looking indicators of monetary conditions (interest rates and inflation), asset valuations in capital markets (equity and debt prices), and general risk aversion (credit spreads).

45. The NBB defined two adverse scenarios based on a historical data of market risk factors and two insurance risks (in the form of a nonlife catastrophe and a life insurance mass lapse event). The NBB calibrated four market risk factors—interest rates, equity prices, corporate spreads, and sovereign spreads—for a mild and a severe adverse scenario, together with a mass lapse event in the life business and the realization of the largest probable maximum losses (PML) on a single (man-made or natural) catastrophic tail event (Table 8).20 The nonlife catastrophe and the life insurance mass lapse were identical for both scenarios.

46. Insurers calculated the overall capital impact by aggregating the individual impact of each risk factor, using a correlation approach, similar to the technique applied within the Solvency II standard formula (Box 1). The amount of own funds available under each scenario is then compared with the Solvency Capital Requirement (SCR) and the Minimum Capital Requirement (MCR), subject to eligibility conditions. This can be seen as a slight simplification, since the SCR and the MCR change during times of stress. However, the main effect of the scenario is its impact on own funds, rather than on SCR.21 Also the impact of general conditions affecting risk factors, such as the upcoming regulatory reforms were examined as the sector transitions from the current Solvency I regime to a more risk-based solvency standard (Solvency II).

47. Six single-factor shocks have been applied to pre-stress balance sheets as at end-June 2012 (Figure 12). The NBB specified the following risk factors for a mild and a severe adverse scenario, based on model output (e.g., in the case of interest rates), expert judgment (in the case of insurance risks), and parameter estimates from the banking stress test (in the case sovereign risk under the current regulatory regime), allowing the participating insurers to determine the capital impact (Table 8):

  • Interest rates: A horizontal downward shift of the yield curve.

  • Equity prices: A downward shock for equity exposures, based on re-sampled monthly data.

  • Credit spreads: Bond stress factors (i.e., rising credit spreads) defined for different rating classes, using empirical Value-at-Risk (VaR) with corporate bonds subdivided into financials and nonfinancials.

Figure 12.
Figure 12.

Belgium: Insurance Stress Test Results

Citation: IMF Staff Country Reports 2013, 137; 10.5089/9781484381069.002.A001

Source: NBB and IMF staff calculations. Box plots include the weighted average (yellow dot) and the 25th and 75th percentiles (grey box, with the change of shading indicating the median). 1/ The prestress level of the weighted-average solvency ratio under MCV was set to 100 as a reference basis for the pre-stress level under QIS-5 as well as all scenario-based results.

Review of Aggregation Approach

Iinsurers combine the individual impact for each of the six risk factors—interest rate risk, equity risk, spread risk, sovereign risk, nonlife catastrophe risk and life insurance mass lapse risk in order to arrive at the total capital impact under for each scenario. In a first step, the four market risk factors are aggregated to a total impact due to market risk factor changes. The technique of the correlation matrix is similar to the one used by the Solvency II standard formula. Although, the actual correlation figures used here were derived only for the purpose of this stress test:

ImpactMarket=(ImpactInterestRates,ImpactEquity,ImpactCreditSpread,ImpactSoverign)
(TotalImpactMarket)2=(ImpactMarket)[10.250.250.250.251110.251110.25111](ImpactMarket)T

In a second step, the total impact due to market risk factor changes is aggregated with the impacts due to nonlife catastrophe risk factor changes and life insurance mass lapse risk factor changes, using again a correlation matrix from the Solvency II standard formula. This results then in the total impact due to all risk factor changes.

(TotalImpact)2=(TotalImpactMarket,ImpactNonlife,ImpactLife)[10.250.50.2510.250.50.251][TotalImpactMarketImpactNonlifeImpactLife]

Also an alternate aggregation was considered, resulting in additive adverse scenarios. Here, the impacts of the six risk factors are summed up rather than aggregated by using correlation matrices. The additive scenarios maintain the same risk impacts under both adverse scenarios, except for the equity stress and catastrophe risk factors, which are not taken into account. This describes a stress in the Euro area with lower interest rates, and higher sovereign and corporate spreads but without an additional nonlife catastrophe occurring. Investors do no exit the equity market, leading to flat equity prices, but an increase in life insurance lapses is observed. The additive aggregation implies a determinist scenario, rather than a stochastic event as is implied by the NBB aggregation.

  • Sovereign spreads: A decrease of the valuation of sovereign debt holdings for different countries based on haircuts estimated as of mid-2012.22

  • Nonlife catastrophe event: The largest probable maximum loss (PML) for nonlife exposures for a single catastrophic event (natural or man-made) on a 1-in-40 year basis.

  • Life insurance mass lapse event: A 30 percent mass lapse rate for all life insurance policies for which the lapse would cause a loss.

48. The impact of individual stress scenarios under three different solvency standards was calculated: Solvency I, the future solvency standard (Solvency II) tested under the latest EU quantitative impact study (QIS-5), and a full “market-consistent valuation” (MCV) method. The MCV calculation was completed by the participating insurers, while the NBB determined the Solvency I and QIS-5 results. The MCV is based on replicating insurance liability cash flows with sovereign bonds only, which have reliable market prices and do not introduce additional credit or liquidity risks into the valuation. Even though the current regulatory regime is based on Solvency I, the absence of risk-based elements makes this standard less suitable for the quantification of the economic impact of capital market events. Equally, elements of QIS-5 (e.g., the illiquidity premium) dampen by construction the economic impact of spread and interest rate shocks. The full MCV leads to a more realistic capital assessment.

49. The stress test was as much an assessment of the different valuation standards as of the participating insurers. It is important to put the results of the NBB insurance stress test into context, in particular when comparing against other sectors and other jurisdictions. Application of the MCV standard results in a reliable and objective view of the economic costs of the insurance liabilities, but results in materially lower solvency ratios than under QIS-5. Not using concepts like the counter-cyclical premium (CCP) and the matching adjustment leads to lower solvency ratios and a stronger impact of market stress scenarios than we can reasonably expected under the future Solvency II framework.23 The effect is even more pronounced when comparing MCV-based results against the Solvency I. Solvency I ratios react very weakly to stresses, leading to generally very stable Solvency I margins (Box 2).

Key Elements of Different Valuation Approaches Applied in the Stress Test

Solvency I Basis—The NBB performed an in-house analysis on the impact of both adverse scenarios on the Solvency I ratio at a legal-entity level. The Solvency I ratio was approximated by applying haircuts for the impact of market risk factors under the market-consistent valuation underlying the reported stress test results. If market values fell below the accounting values, the entire difference was assumed to be impaired and was passed through the own funds margin. Equally, the available solvency capital includes all net unrealized capital gains and losses. Then the impacts due to the changes in risk factors were added together rather than aggregated using correlation matrices.

Market Consistent Valuation (MCV) Basis—Insurers calculated the balance sheet both pre-stress and poststress based on a MCV standard. The following specifications were used for the balance sheet valuation and the calculation of solvency capital requirements: (i) The technical specifications of the QIS5 exercise were updated for the relevant Level 2 Draft Implementing Measures and (where available and relevant) the Level 3 Draft Technical Standards and Guidelines. The dampeners of the long-term guarantee package, i.e., countercyclical premium, (extended) matching adjustment, and the convergence period for extrapolating the basic risk free curve were not included; (ii) the discount curves were extrapolated based on the Smith-Wilson method, assuming an Ultimate Forward Rate (UFR) of 4.2 percent and the last liquid point at a maturity tenor of 20 years for the Euro, 50 years for the British Pound, and 30 years for the U.S. dollar. The convergence speed is such that there is a 3 basis point deviation within 40 years to the UFR. Credit risk is taken into account by a 10 basis point downward adjustment to the calculated forward rates. This approach results overall in a market consistent valuation since the valuation of the insurance liabilities is based on financial instruments with reliable market prices and without introducing unnecessary credit risks and valuation uncertainty.

QIS-5 Basis—The stress scenarios were also evaluated using the Solvency II specification in QIS-5. This valuation basis includes the illiquidity premium, which decreases the sensitivity to interest rate and spread changes, which results in lower technical provisions and higher own funds.

50. Insurers’ capital levels are sufficient under the current regulatory regime but the sector appears vulnerable to downside risks from market shocks, especially after the transition to a risk-based solvency framework. With the exception of one firm, all insurers exceeded the minimum Solvency I ratio under both adverse scenarios. More specifically, the results suggest that hidden reserves, i.e., net unrealized capital gains included in the statutory solvency margin, were sufficient to buffer the impact of significant market risk shocks as well as an escalation of underwriting risks.

51. While a few insurers exhibit sufficient capital buffers, most firms are likely to experience a significant decline in solvency ratios when measured using the more risk-sensitive valuation method. For QIS-5 results, the industry is generally resilient to adverse scenarios in spite of a decline of the pre-stress median solvency ratio by 68 percentage points compared to Solvency I. However, the application of MCV indicates a significant erosion of capital, calling into question some business models over the medium term.24 The average weighted solvency ratio drops materially relative to the QIS-5 results under both adverse scenarios, respectively.25 Even though such a decline in solvency conditions might be manageable if timely measures were taken, it could impose excessive strains on the market, with potentially knock-on effects to the financial sector at large.

52. The solvency position of insurers is significantly impacted by sovereign risk. The market-implied valuation haircuts used for the banking sector stress test have also been applied to all direct and indirect exposures of insurers at mid-2012 prices, which decrease the QIS-5 solvency ratio with weighted solvency components (SCRs) by 54 and 45 percentage points under both adverse scenarios, respectively (and between 30 and 46 percentage points without using a correlation approach for aggregating risk factors).

53. Liquidity risk could further amplify solvency pressures of insurers within conglomerate structures. Insurers that are part of a conglomerate might find it expedient to transfer their liquid assets in exchange for illiquid ones from the banking operations potentially increasing the expect yield of their assets (Box 3). In particular, for weak insurers, there is an incentive to increase investments in illiquid assets to benefit from the additional spread and to gradually improve the solvency position. However, a rise in credit spreads in tandem with greater market uncertainty would put a premium on the asset liquidity of investments held by insurers that experience a significant capital shortfall in both adverse scenarios.

54. Neither nonlife catastrophe risk nor equity risk was material for the financial soundness of insurers. Sovereign risk, corporate spreads and interest rate risks were the main drivers of the solvency. Specific risks, e.g., legal risk or contagion risk within the group or conglomerate, could also be relevant but were not covered by the stress test and, therefore, should be analyzed separately.

Contagion Effects in Bancassurance

Liquidity risk in the banking sector can cause negative externalities, with possible implications for insurance companies based on their asset exposures and/or relationships with banks within conglomerate structures. Insurers that are part of conglomerates are susceptible to contagion effects and liquidity risk.

While the long-term funding profile of insurers is less susceptible to funding shocks (although such risks cannot be excluded particularly in life insurance), contingent intragroup obligations could create vulnerabilities. For instance, asset liquidity swaps and securities lending establish cash flow requirements for a transaction-based business that are markedly different from long-term cash flow projections associated with insurance liabilities and are inherently more susceptible to the financial market effects. Also the banking side of conglomerates could become vulnerable to the risk of large withdrawals of deposits and/or the runoff of liabilities, with both banking and insurance activities sustaining a sharp decrease in the value of investment portfolios, which in turn could lead to greater reliance on intragroup transactions.

Moreover, the crisis revealed that negative externalities of liquidity risk management precipitated collective insolvency problems. Many business models of banks—but also a number of nonbank financial institutions, such as insurance firms—were vulnerable to sharp declines in financial asset prices, which increased counterparty risks, undermined solvency, and led to a collapse of private markets outside the scope of regulated financial intermediation. However, in such situations it also becomes more difficult to delineate the cause and effect of the negative dynamics that afflicted both banking and insurance operations.

There are five large, bank-dominated conglomerates in Belgium, all of which were included in both banking and insurance stress testing exercises of the FSAP. Some of these firms report contingent intragroup obligations that could result in considerable changes in cash flow projections during periods of stress, with potential implications for solvency ratios. However, funding obligations from banking operations to other activities within the conglomerate are beyond a one-month maturity tenor (with some related to arrangements related to legacy portfolios and/or organizational structures that existed prior to the consolidation and asset reduction of the sector). Based on the liquidity stress test results, some banks within conglomerate structures exhibit limited sensitivity to a reduction of intragroup funding support to banking activities (Figure 11). In general, systemic spillovers resulting from this linkage have yet to be observed in jurisdictions with an active bancassurance sector (IAIS, 2011). That being said, the 2009 example of capital support provided by the Dutch government to the bancassurance groups—ING Group, Aegon Group and SNS Reaal—to mitigate the contagion risk from their banking operations demonstrates that such vulnerabilities do indeed exist.

Conglomerates could also engage in liquidity transformation between the insurance and banking entities where liquid assets were transferred to the banking entity in exchange for less liquid assets. This allows the banking part of the conglomerate to satisfy Basel III liquidity requirements, while the insurer benefits from higher asset returns. While this might seem as a win-win situation for the conglomerate in the near term, in time of stressed financial markets, the insurer will be exposed to liquidity shocks and to deteriorating asset values. The argument that insurers can hold assets to maturity and are therefore less impacted by asset value declines is not convincing. In reality, insurers have an active asset-liability management. This underlines the importance of strengthening conglomerate supervisory framework and associated corporate governance requirements which will help raise the NBB’s awareness of potential underlying conflicts of interests that can arise from such and similar transactions within insurers and banks within a conglomerate.1

1For more detail see the Technical Note on Financial Conglomerates Supervision.

Summary and Policy Implications—Insurance

55. Authorities are encouraged to continue to apply a MCV approach in assessing the solvency position of insurers under stress. The results obtained from the stress test can inform a thematic review of key vulnerabilities and help integrate stress testing with the prudential supervision of insurers. This approach generates valuable information on the individual and system-wide vulnerabilities of insurers to specific events and risk factors, which also allows the NBB to determine the extent to which dampeners being used in Solvency II could distort the actual solvency position of insurers. These insights would also inform the policy position of the NBB regarding the relevance of these elements in the implementation of Solvency II. In contrast, valuation standards that use illiquidity premiums or matching adjustments—such as currently discussed for Solvency II—introduce additional valuation uncertainty (e.g., via the replication with illiquid financial instruments or with the assets being held by the insurer).

56. Simplifying the approach for aggregating the impacts of single risk factors would make the scenarios of the regular stress tests more intuitive. While it is generally straightforward to generate stress test results based on the effect of a single risk, combining multiple risk factors (and the extent to which firms might affect each other in terms of default risk) under different scenarios tends to complicate a reliable capital assessment. In particular, most conventional balance sheet-based stress tests account for diversification effects, which recognize the potential role of dependencies, but possibly underestimate joint outcomes.

57. The authorities could consider an alternative to the aggregation approach underpinning the calculation of the total stress impact. Under the current specification, the total impact is derived from aggregating the individual impacts of the market risk factors using a correlation matrix, and then aggregating this result with the two insurance risk factors using another correlation matrix. Mathematically, this approach implies that the changes of the six risk factors are random with a given correlation. The total impact is calculated assuming that both adverse scenarios are random events. More intuitive would be to consider the total impact based on a linear combination of the six separate risk factor impacts. Such an aggregation would allow for a simpler and more intuitive interpretation of the scenario, allowing for the formulation of deterministic events.

58. The NBB should extend the number of scenarios and supplement them with narratives. The data on the single risk factor impacts can be used to arrive at different combinations and magnitudes of changes in the six risk factors. This would allow the NBB to extend the analysis beyond both adverse scenarios and include the assessment of the impact of events with different magnitude in changes of risk factors. The buy-in by stakeholders of the stress test could be enhanced if the scenarios were explained and described in a narrative form. This would allow a discussion of the scenarios with different stakeholders, and would facilitate the analysis and improvements of the specification of the risk factors.

59. Extending the stress test horizon would help identify medium- and long-term vulnerabilities. Given the exposure of life insurers to a prolonged low-interest rate environment, the NBB might consider conducting multi-year stress testing. This would allow the NBB to analyze the risk of a gradual erosion of the solvency position of life insurers and to require the implementation of recovery plans, where this is seen to be necessary.

60. The NBB should consider integrating stress test into the solvency assessment of insurers. Even if no probabilities can or are intended to be assigned to scenarios, the NBB could still require from insurers the ability to survive certain scenarios. For example, irrespective of the likelihood of a further sovereign spread widening occurring, the NBB could decide that such an event of a certain magnitude has to be within the risk bearing capabilities of insurers. Such an approach could be a valuable complement to the Solvency II requirements.

61. The authorities are encouraged to deepen the analysis of the impact of scenarios on intragroup transactions within insurance groups and conglomerates. Intragroup transactions or transactions between banking and insurance legal entities within a conglomerate can be very material for the exposures to risk and for the capital and liquidity positions of legal entities within the groups and conglomerates. Currently, the insurance stress test focuses on a consolidated view, which is in line with the Solvency II approach. The stress test should require a more detailed analysis of intragroup transactions. Such an analysis should include the assessment of the capital and liquidity positions of legal entities that are part of groups or conglomerates, taking into account the transferability of assets between different legal entities and potential legal and regulatory constraints.

62. The current practice of requiring participating insurers to include secondary impacts should be continued and deepened. Secondary impacts emanating from a deteriorating financial position can be material. In particular in situations of financial stress or distress, secondary impacts, e.g., potential changes in MCV in a run-off situation, higher cost of capital, the impact of rating downgrades and of intragroup transactions, constrained capital mobility, can become important. The detailed analysis of secondary impacts should be linked to contingency and recovery and resolution planning.

63. The implementation of stress tests needs to be closely aligned with the resolution and recovery planning. Developing a medium-term strategy for the insurance sector consolidation is warranted. For insurers that are overly exposed to adverse but plausible shocks, contingency plans should be prepared by both insurance companies and the authorities. For a number of insurers, timely remedial actions would improve their resilience. These actions can range from short-term measures, such as de-risking their investment portfolio and improving the asset liability matching, to capital transfers from groups and conglomerates or restrictions on writing certain lines of business, and finally to the consideration of run-off. For groups and conglomerates, increasing focus should be placed on potential secondary effects in situations where scenarios cause financial strain, i.e., the impact of rating downgrades, spillover, and contagion effects between different legal entities within groups and conglomerates via intragroup transactions

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