INTERNATIONAL MONETARY FUND

Workshop 1. Introduction to FSI and Stress Testing

Part I

QUESTIONS

Course on Macro Prudential Policies

October 14-18, 2013

Note: This training material is the property of the International Monetary Fund (IMF) and is
intended for use in IMF courses. Any reuse requires the permission of the IMF Institute for
Capacity Development
 Stress Testing the Banking System

INTRODUCTION TO THE STRESS TESTER FRAMEWORK

(Cihak, M., 2007, Introduction to Applied Stress Testing, IMF working paper WP/07/59)

This workshop uses an Excel-based model of a hypothetical banking system for the country
of Bankistan. The Excel file you will be using consists of the following worksheets:

Read Me: summarizes the content of each of the worksheets.

Data: contains balance sheet and income statement information as well as the main
Financial Soundness Indicators (FSI) for each of the banks in the country. You will see that
the banking system includes three state banks (SBi), five private domestic banks (DBi), and
four foreign banks (FBi), for a total of twelve banks. Individual banks are displayed in
columns F-Q, subtotals are shown in columns B-E, and the consolidated banking system is
shown in column B. The main tables on this sheet are:

Table A.1 Balance Sheet and Income Statement Data

Table A.2 Other Input Data, contains some more detailed and useful banking
information, such as: capital adequacy (note that in this simple framework, Regulatory
Capital is equal to Total Capital), sectoral structure of lending, exposure to large borrowers,
assets and liabilities sensitive to interest rate fluctuations, exposure to government bonds, and
the foreign exchange open position. Finally, the table contains each banks exposure to other
banks through the interbank market.

Table A.3 Selected Banking Sector Ratios, which are calculated from the basic
information contained in Tables A.1 and A.2.

Table A.4 Structure of the Financial System: computes the share of each bank in the
system total for different variables (assets, loans, deposits, and capital), and the asset-GDP
ratio.

Tables A.5 and A.6 Basic Ratio Analysis: uses the FSIs calculated in Table A.2 to
assess the probability of default. This table compares actual values with ranges linked first to
ratings and then to historical probabilities of default, as expressed in the Assumptions sheet,
Table B: Basic Ratio Analysis.

Assumptions: in addition to the Basic Ratio Analysis table, this sheet also contains the
areas where the stress tests are conducted, that is, different types of shocks are incorporated
into the banking system.
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General Questions

1. Examine the formulas in Tables A.5 and A.6, which are used to calculate the
probabilities of bank failure. Describe in words the procedure involved. What type of
information would be necessary to carry out this type of analysis in real life (for example, if
it is to be applied to your country)?

2. According to the probabilities computed in the file, evaluate the initial financial
situation of the banking system as a whole, the subgroups, as well as individual banks. How
solid does it look? What appear to be the main sources of vulnerability or danger in the
system? Are there specific banks that should be watched carefully? If so, where do their
vulnerabilities lie?

Stress Testing of the Banking System

In this section you will work through a series of stress tests, simulating the impact of
different exogenous shocks on the system.

3. Credit Risk

Technical note on the model: the last sheet of the file, Scenarios, summarizes the final
results for each of the experiments. These results are then displayed in the graphs that appear
in the Assumptions sheet. For each type of shock, the model must choose which of the
experiments is being run. For the credit risk shocks in particular, you must choose which of
the experiments to analyze by entering a number in cell B69 of the Assumptions sheet.
You can observe that the initial value is 2, corresponding to Shock 2, an overall increase in
NPLs. Therefore, and given that additional exogenous (interest rate or FX) shocks have not
yet been entered, the graphs should be currently displaying the results of this credit shock. In
order to see the results of the other credit shock experiments in the graphs, simply change the
value of B69 to 3 (sectoral shocks) or 4 (exposure to large borrowers). Also, recall that all
scenarios include the initial shock, of provisioning up to the legal requirement.

Credit Shock 1: Initial Loan Loss Provisions

In this framework, the first change in the system actually occurs before any shock to a
risk factor has been incorporated, and is due to the fact that some banks are in an initial
situation of underprovisioning, given the quality of their credit portfolio. The first step of this
experiment is to introduce minimum legal levels of provisioning. In the Assumptions
sheet, go to the Credit Risk section, which begins on row 24. As you can observe, there is
a range of cells (B27:B33) shaded green, to indicate that they are numerical assumptions for
the stress test. In these cells, enter the following minimum legal provisioning requirements:
1% for Pass Loans, 3% for Special Mention Loans, 20% for Substandard Loans, 50% for
 4

Doubtful Loans, and finally 100% for the lowest category, Loss Loans. Also assume that in
case of seizure of collateral, the bank will suffer a 75% haircut, and that additional
provisioning will affect bank capital one-for-one, that is, its impact on capital will be 100%.

Once these assumptions are entered, observe the impact of the required provisioning in the
Credit Risk sheet, between rows 25 and 43. NOTE: you can also observe changes in
graphs in the Assumptions sheet, where the pre-shock values (black bar) are compared to
the post-shock but pre-contagion situation (purple bar), as well as in graphs that compute the
capital injection (as a percentage of GDP) required to bring the system back to the required
level.

a) Which banks are affected by these legal provisioning requirements? In other words,
which banks were initially underprovisioned? Which subgroup of banks was affected
the most?

b) What was the overall size of the impact for the system, in terms of capital loss? Did
individual banks or groups of banks end up with insufficient capital as a result? If so,
which ones? Did any bank become technically insolvent (in other words, once
adequate provisioning was accounted for, did any bank end up with negative capital)?
If so, which ones?

c) Cell B71 of the Assumptions sheet sets the minimum capital adequacy at 10% (of
risk-weighted assets, RWA). Observing the first two graphs in the same sheet (in
rows 3-22), what would be the size of the capital injection needed to achieve this
level? What would it be if the requirement were instead 11%, or 9%?

d) [skip] What would happen if the provisioning levels set above were deemed to be
insufficient, according to international standards? For example, assume that in
neighboring or countries with similar levels of financial development the standard
provisioning levels are: 2% for low-risk and 5% for potentially nonperforming loans,
rather than the 1% and 3% levels established above for Bankistan. How do the results
change if these international standards are imposed in Bankistan?

Credit Shock 2 (Increase in NPL)

This experiment, as well as those that follow, is conducted on top of the minimum
provisioning shock of the previous section, in other words, assuming that banks need to
comply with the required level of provisioning. Before proceeding, make sure that the
minimum levels are set to their original values of 3.a), and that the minimum capital
requirement is set at 10% (cell B71 of Assumptions).

Assume that the volume of NPL increases by 25%, by changing the value in cell B35 of
the Assumptions sheet. Note that the blue shading indicates that it is an assumption on the
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magnitude of the shock. You must also indicate whether this 25% increase is with respect to
the initial level of NPL (Option 1 in cell B37, and 0 in cell B38) rather than the initial level of
total loans (Option 0 in cell B37, and 1 in cell B38). Also assume that the additional NPLs
will require 25% provisioning (cell B39), and that the entire impact will fall on bank capital
(100% in cell B40).

Observe the changes in the banking system as a result of this shock (specifically, in the
Credit Risk sheet, in the section corresponding to Shock 2: proportional increase in NPLs,
rows 45-62), and answer the following questions.

e) Which banks become undercapitalized? Which of them fail? Is there any subgroup
that becomes undercapitalized or fails as a group? How large is the required capital
injection for the system as a whole? Which banks would require the largest capital
injections?

f) In the Assumptions sheet, starting in column G, observe the graphs on average

rating (rows 46-64) and probability of failure (rows 70-89) of the banks. What is the
impact of the credit shock? Note that the probability of failure does not generally
reach 100%, even for failed banks. Why is this so?

g) [skip] Now assume that the 25% increase in NPL is with respect to total loans. How
do the results change? Specifically, how many additional funds are required to bring
the system back to an acceptable level of capital? (Note: you need to change the
assumptions in cells B37 and B38)

Credit Shock 3 (Sectoral Shocks) [skip]

In this experiment you will assume that a series of adverse shocks occur in different
productive sectors, thus causing a deterioration in the quality of loans directed to these
sectors. In particular, assume that shocks occur only in the trade and tourism sectors, such
that NPLs in these sectors rise to 10 and 20%, respectively (enter these values in the relevant
blue-shaded cells in the section Shock 3: Sectoral Shocks to NPLs in the Assumptions
sheet. (Recall that the percentage of provisioning of the new NPLs is 25% and that the entire
impact is transmitted to bank capital, 100% ).

In Section 3 of the Credit Risk sheet, observe the changes that occur in bank
capitalization, and then answer the following questions.

h) Which banks are most affected by adverse events in the tourism sector? Which are
most affected by adverse events in the trade sector? What is the overall impact of the
sectoral shocks on the banking system? Alternatively, assume that only the
agricultural sector suffers an adverse shock, increasing its NPLs to 30%. How do the
results differ?
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Credit Shock 4 (Large Exposures)

In this experiment an adverse shock is assumed to hit the largest borrowers of each bank,
such that all of the corresponding loans become nonperforming. The model allows you to
enter the number of borrowers per bank affected by this shock (cell B53). For example, if a
value of 2 is entered, this implies that loans to the two largest borrowers in each bank
become nonperforming1.

i) Assume that the five largest borrowers suffer the adverse shock, and that the
corresponding NPLs require 100% provisioning. How many banks become
undercapitalized, and how many fail? (Section Shock 4: Large Exposures of the
Credit Risk sheet). Note: as in the previous case, the graphs will reflect this
particular experiment if the Scenarios section is set to Credit Shock 4 (in cell B69).

j) [skip] How many adversely affected large borrowers does it take to bankrupt private
bank DB2? How many to bankrupt DB4?

k) [skip] By changing the scenario number in B69 and comparing the graphs, which type
of shock would generate the greatest needed capital injection for the system? Which
type of shock would cause the greatest number of banks to be undercapitalized?
Which would cause the greatest number of bank failures?

4. Interest Rate Risk

This model also allows you to include a shock to interest rates, which would have two
types of effects: (i) an impact on flows of income and costs that are sensitive to the market
interest rate (floating rate assets and liabilities), and (ii) a stock effect on the market value of
each banks holdings of government bonds (Bonds 1 and 2, as described in cells B58:F59 of
the Assumptions sheet). The interest rate shock is entered (in percentage points) in cell
B60 of the Assumptions sheet, and its effects can be observed in the Interest Risk
sheet.

Assume that interest rates increase by 1 percentage points.

a) Which banks can tolerate this increase, and which cannot (i.e., they will fail)? Do any
banks actually benefit from this shock? If so, why?

1
Recall that the basic information contained in Data only specified the exposure of each bank to the five
largest borrowers. Therefore, the model will not accept a value greater than 5 for this cell.
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b) What will be the cost of additional capital required? (Note: in order to use the
calculations of the capital injections from the graphs, you should compare the cost
before and after the interest rate shock, since both cases already include a credit
shock).

5. FX Risk

A nominal depreciation of the domestic currency will have two effects on the banking
systems financial situation: (i) a direct effect, which will depend on the net open foreign
exchange position (assets denominated in foreign currency minus liabilities denominated in
foreign currency). If a bank has a positive (negative) net open position, it will directly benefit
(be hurt by) by a depreciation; (ii) an indirect effect, whereby domestic borrowers of foreign
currency-denominated loans will be hurt by the depreciation, and therefore their capacity to
repay the loans will be impaired.

Direct FX Risk

a) Assume that the Bankistan currency depreciates instantaneously by 55%, which is

entered in cell B63 of the Assumptions sheet. Analyze the results in the FX
Risk sheet. Which banks become undercapitalized, and which fail as a result of the
FX shock? Do any banks benefit?

Indirect FX Risk

b) Now assume an exchange rate elasticity of NPLs among foreign-currency

borrowers of 0.10, that is, that for every 100 percentage points of depreciation NPLs
of these borrowers increases by 10% (this assumption is entered in cell B65), and that
these additional NPLs generate additional requirements for provisions by 50% (cell
B66).2 Which banks are most vulnerable to indirect FX risk? How do the results
change if the elasticity is changed to 0.25?

6. Contagion (skip)

7. Liquidity Risk (Optional Exercise)

The model includes several alternatives for introducing a liquidity shock or a deposit
run on the banking system. Two main types of runs are considered: (i) simple or
indiscriminate runs, which affect all banks equally, and (ii) differential or discriminating
runs, in which depositors distinguish between types of banks, and undertake a flight to

2
In case of an appreciation of the exchange rate, this number should be set to zero.
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quality. In this case, depositors may focus on different characteristics of banks, such as size,
ownership (public or private), or their pre-shock ratings.3

Simple Deposit Run

The simple run is specified by entering 1 in cell B80. Cells B83:B89 then define the
run as a daily withdrawal equivalent to 15% for domestic-currency demand deposits, 10% for
foreign-currency demand deposits, 3% for domestic-currency time deposits, and 1% for
foreign-currency time deposits.

The experiment proceeds as follows. Each bank suffers a deposit withdrawal as

defined above. In order to meet these obligations, banks must then sell their liquid and non-
liquid assets, given the following availability rates: 95% for liquid assets, 1% for non-liquid
assets. In this manner, at the end of each day, a given bank will have a cumulative cash
inflow equal to the sale of assets, which is then compared to the cumulative outflow, that is,
the deposit withdrawal. A bank is said to become illiquid when the difference between the
two becomes negative. The exercise is repeated over five consecutive days.

a) Analyze the results of the simple deposit run in the Liquidity sheet. Which are the
first banks to become illiquid? How many days does it take for the subgroup of
private domestic banks to become illiquid?

b) How do the results change if the percentage outflow of foreign-currency deposits is

assumed to be equal to that of domestic-currency deposits? How do the results change
of the availability of non-liquid assets is equal to 2% instead of 1%?

3
Note that in this workshop you will not be analyzing the third possible scenario (Option 3 in cell B80), of
government default causing its bonds to become illiquid.