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Stress Testing Exercise for Banks 2015

Stress Testing Exercise for BanksSyed Danish Ali

1. Introduction

1.1. Executive Summary

1.1.1. The objective is to conduct stress testing of the bank’s financial position and what outcomes can be applied to better equip the management in dealing with such crisis situations.

1.1.2. The base date used is December 31st 2011. As banks carry contagion risk, which is the risk of loss of one bank leading to losses in the whole sector, we have compiled similar analysis for the Top 5 banks of Pakistan along with Askari Bank using publicly available data from annual reports. These top 5 banks represent about 80% of market capitalization. They will be presented in the same line as Askari Bank for sake of comparison and taking account of contagion risk.

1.1.3. Data has been compiled from bank’s Balance Sheet, Income Statement and significantly from the notes to the accounts.

1.1.4. A key message of this report is to emphasize that assumptions matter, especially in case of stress testing. To highlight its importance, main assumptions have been outlined in this report along with the results.

1.1.5. Stress testing has been carried out in compliance with State Bank of Pakistan (SBP) Regulations chiefly BSD Circular No.1 of 2012. Basel II compliance has also been fully taken into account.

2. Stress testing – an Overview

2.1.1. Stress testing is a risk management tool used to assess the potential vulnerability of a financial institution to exceptional but plausible events. These events are known for their severity and low probability of occurring, and include extreme or worst-case events. More specifically, stress testing can be used to assess the potential impact of events or movements of combined factors on the different components of an insurer (sectors, portfolios, etc.).

2.1.2. Two of the main approaches generally underlie the techniques used in performing a stress test;

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2.1.3. Sensitivity analysis: This approach consists of varying a single risk factor (assumption, parameter etc) or a limited subset of risk factors. Since it is an oversimplified way of looking at events, it is rarely considered.

2.1.4. Scenario analysis: This approach is designed to assess the impact of a simultaneous variation in a complete set of factors in order to reflect an event that could occur in the future. The event underlying the scenario should be clearly defined.

2.1.5. A scenario analysis of a short-term drop in interest rates would specify the cause of the drop and, unlike a sensitivity analysis, would also include its effects on all other pertinent economic factors for the company.

2.1.6. The scenarios developed can be hypothetical or historical, i.e. based on past events that are deemed likely to recur. They should incorporate atypical elements, such as the effects of a perfect correlation between types of risk in a stress situation. The parameters (factors considered, scale of shocks, etc.) may differ from one scenario to another, but must be consistent with one another and relevant to the purpose of each of the analyses.

2.1.7. Irrespective of the approach taken by the bank, it is expected that prudent, well-managed management would undertake stress testing as a matter of good corporate governance, which should result in better internal controls, governance and risk management.

2.1.8. To be truly effective, stress tests should be considered as a fundamental element in the bank’s overall risk management framework, rather than being viewed simply as a helpful tool for capital allocation purposes or as a way to monitor performance. The use of such tests should not be seen as a regulatory burden.

2.1.9. Stress testing should contribute to the understanding that the board and management has of the risks facing the bank. To accomplish this, the board and management must understand the assumptions underlying the stress testing, as well as the results. Also, stress tests can help an insurer to develop and assess alternative strategies for mitigating its risks.

3. Stress Scenario

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3.1.1. It is imperative to understand the scenario we have considered for purposes of stress testing before embarking on the results and assumptions.

3.1.2. The economic environment in which banks are operating in Pakistan is challenging, with increasing macroeconomic imbalances, inappropriate macroeconomic policies and deep uncertainty fueled by political tensions. Real activity is sharply contracting and inflation is continuing to rise steeply.

3.1.3. Unsustainable fiscal imbalances and loose monetary policies were key to the deteriorating situation in Pakistan. The government deficit has doubled in just a few years and a sharp increase in central bank financing of the government has significantly accelerated money growth.

3.1.4. The deteriorating macroeconomic environment has put considerable strain on the financial condition of the banking system.

3.1.5. Even though the system has proved so far to be remarkably resilient, some banks have been weakened considerably, and are prone to further deterioration in light of the significant risks. Reported high capital adequacy ratios were found to be overstated due to insufficient provisioning. In addition, asset quality has deteriorated. The ratio of gross nonperforming loans (NPLs) to total loans has increased.

4. Credit Risk

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4.1.1. Credit risk is the risk of loss of principal or loss of a financial reward stemming from a borrower's failure to repay a loan or otherwise meet a contractual obligation. Credit risk is the most significant risk confronted by the lending institutions thus the banks should meticulously manage it.

4.1.2. In Credit Shock 1, we gauge what would happen if banks corrected their currently insufficient provisioning to fully meet the provisioning requirements. It is also very difficult to foreclose collateral in Pakistan so we assume that the actual value of reported collateral is only 25% of what it is reported, i.e, a haircut assumption of 75%.

4.1.3. Credit Shock 2 ‘Increase in NPLs’ models a general decline in the asset quality, affecting all banks proportionately.

4.1.4. Credit Shock 3 ‘Sectoral Shocks’ includes that terrorism is inflicting its toll on to the trade and tourism sector of loans. Also load shedding of electricity and gas leads to significant reduction in manufacturing sector of loans.

4.1.5. Credit Shock 4 ‘Concentration Risk’ allows testing for the failure of the largest counterparties of individual banks.

4.2. Assumptions

4.2.1. The main assumptions covered under Credit Risk Shock 1 are shown below:

Fig 1 Credit Shock 1 Assumptions4.2.2. The main assumptions covered under Credit Risk Shock 2 are shown below:

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Fig 2 Credit Shock 2 Assumptions

4.2.3. The main assumptions covered under Credit Risk Shock 3 are shown below:

Fig 3 Credit Shock 3 Assumptions4.2.4. The main assumptions covered under Credit Risk Shock 4 are shown below:

Fig 4 Credit Shock 4 Assumptions

4.3. Results

4.3.1. The results of stressing Credit Risk are shown in terms of impact shocks have on the Capital Adequacy Ratio (CAR). The minimum CAR that has to be maintained under regulations is 10%.The result is shown below:

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Fig 5 Credit Risk Shock Impact

4.3.2. As can be seen the impact of Credit Risk on AKBL is very significant.

5. Market Risk

5.1.1. Market risk is the risk that the value of on and off–balance sheet positions of a financial institution will be adversely affected by movements in market rates or prices such as interest rates, foreign exchange rates, equity prices and credit spreads resulting in a loss to earnings and capital.

5.1.2. Here we consider Interest Rate Risk, Currency Risk and Equity Risk.

5.2. Interest Rate Risk

5.2.1. Direct interest rate risk is the risk incurred by a financial institution when the interest ratesensitivities of its assets and liabilities are mismatched. In addition, the financial institution isalso exposed to indirect interest rate risk, resulting from the impact of interest rate changeson borrowers’ creditworthiness and ability to repay.

5.2.2. Direct interest rate risk calculates the changes in interest income and interest expenses resulting from the “gap” between the flow of interest on the holdings of assets and liabilities in each bucket. The “gap” in each time band or time-to-repricing bucket shows how net interest income will be affected by a given change in interest rates. It sorts assets and liabilities into three time-to-repricing buckets (due in less than 3 months, due in 3 to 6 months, due in 6 to 12 months)

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5.2.3. The indirect interest rate risk is repricing impact. An increase in nominal interest rates—to the extent that it increases real interest rates and makes it more difficult for borrowers to repay their debts and to obtain new credit—is likely to have a negative effect on the credit risk of the financial institutions’ borrowers. Other things being equal, higher risk eventually translates into higher losses and a decline in the financial institutions’ net worth.

5.2.4. Country case studies find a positive relationship between higher interest rates and nonperforming loans or loan losses.

Assumptions

5.2.5. The main assumption is highlighted below:

Fig 6 Interest Rate Risk Assumption

Results

5.2.6. The results are shown below:

Fig 7 Overall Interest Rate Risk Impact

5.3. Exchange Rate/Forex Rate Risk

5.3.1. The direct exchange rate risk is that exchange rate changes affect the local currency value of financial institutions’ assets, liabilities, and off-balance sheet items.

5.3.2. Only a very limited number of banks have short positions, therefore the direct depreciationeffects are very small—some banks would even gain from a depreciation. Given that most

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central banks impose limits on foreign exchange positions to capital, this result is notunusual. For most banking systems, the direct foreign exchange solvency risk is rather small.

5.3.3. The indirect exchange rate risk is forex loans becoming NPL. A change in the exchange rate would also influence the creditworthiness and ability to repay of the corporate sector.

Assumptions

5.3.4. The main assumptions relating to forex rate risk are highlighted below:

Fig 8 Exchange Rate Risk Assumptions

Results

5.3.5. The results relating to forex rate risk are shown below:

Fig 9 Overall Exchange Rate Risk Impact

Equity Risk

5.3.6. It is anticipated than in the stress scenario, equity prices will fall at an average of 30%. The volatility of the prices will also increase.

5.3.7. The results of equity shock are as follows:

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Fig 10 Overall Equity Risk Impact

6. Operational Risk

6.1.1. Operational risk is the risk resulting from breakdowns in internal procedures, people and systems.

6.1.2. Due to uncertainty in the economy and high inflation there will be more occurrences of fraud and/or failing to perform procedures. It has been assumed that operational risk will increase by 50% to what amount it is currently on Dec 31st, 2011.

6.1.3. The results of this are shown below:

Fig 11 Overall Operational Risk Impact

7. Liquidity Risk

7.1.1. Liquidity Risk has been assessed on two frameworks. The first is the same framework of seeing impact on CAR. The second, however, has a different framework than that of CAR.

7.1.2. In the second framework, the impact for each bank is shown in terms of number of days it would be able to survive a liquidity drain of run on the bank without resorting to liquidity from outside (other banks or SBP).

7.2. Assumptions

7.2.1. The main assumptions covered under both frameworks are shown below:

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Fig 12 Liquidity Risk Assumptions

7.2.2. It is also important to mention the following assumptions:

Fig 13 More Liquidity Risk Assumptions

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7.3. Results

7.3.1. The results according to CAR framework is detailed below:

Fig 14 Overall Liquidity Risk Impact

7.3.2. Liquidity stress testing under the second framework contains two instances of liquidity tests. The first test ‘Basic Liquidity Test (Proportional Withdrawals) models a liquidity drain that affects all banks in the system proportionately, depending on their volumes of current and saving accounts, the percentage of assets the bank can convert into cash each day and so on.

7.3.3. Regulators use a 5 day period to assess the impact of such liquidity risk. The results of the first test are depicted below:

Fig 15 Basic Liquidity Test

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7.3.4. The second test ‘Flight to safety/ Contagion Impact on Liquidity’ models liquidity contagion where the liquidity drain starts in the smallest banks and how this goes on to affect larger banks as well. It also combines the liquidity impact of government default with a bank run.

7.3.5. The results of the second test are depicted below:

Fig 16 Contagion Impact on Liquidity

7.3.6. This reveals an important insight that AKBL is more vulnerable to contagion liquidity risk than the other major 5 banks of Pakistan.

8. Contagion Risk

8.1.1. Here two types of contagion risks are assessed. Pure interbank contagion is to assess what happens if banks fail on their interbank lending’s to each other. The stress test is run in several iterations, as the contagion-induced failures (“first iteration”) can induce failures in other banks (“second iteration”), which can lead to further failures (“third iteration”), and so on.

8.1.2. To present the results in terms of capital adequacy for both first type and second of contagion risk, the model uses an assumption on the Risk-weight of the interbank loans that becomes unpaid. Reflecting the typical Basel 2weight for interbank loans, this assumption is set at 20 percent.

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8.1.3. The second type of contagion is ‘Macro Interbank Contagion’. In this case, we model when bank failures are triggered by macroeconomic developments mentioned in the stress scenario. Iterations are run for the same reason as that for Pure interbank contagion.

8.1.4. What is the key difference between the “pure” and the “macro” contagion tests? The “pure”contagion test assumes that a failure occurs in a single bank, for example for some internalreason (e.g., because of a large fraud in the bank); it does not distinguish the relative likelihood of the failure of various banks. This is what the “macro” contagion test does.

8.1.5. The macro contagion test analyzes situations when all banks are weakened at the same time by a common external (typically macroeconomic) shock, which affects each bank differently depending on its exposures to the various risk factors, and makes some of the banks (perhaps more than one)fail.

8.2. Results

8.2.1. The combined results of both types of contagion risk are shown below:

Fig 17 Overall Contagion Risk Impact

8.2.2. This shows that on its own, Contagion risk is enough to wipe off the entire CAR of AKBL.

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9. Combined Results

9.1.1. The results are so far discussed according to type of risks. Here we aggregate the impacts of stressing those risks and seeing the overall picture this stress testing exercise presents for the management.

9.1.2. The aggregate results are shown below:

Fig 18 Combined Results of Stress Testing

9.1.3. As can be seen, AKBL is hurt most in terms of CAR but in terms of actual PKR millions of capital injection needed to rectify the situation back to the minimum CAR of 10% it is not hurt the most.

9.1.4. The stress testing exercise is meant to be comprehensive. Therefore, not only CAR change has been calculated, but a host of banking ratios has been calculated both before the shocks and after the shocks for use by the management.

9.1.5. The banking ratios pre shocks are shown here below:

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Fig 19 Pre Shock Banking Ratios

9.1.6. The banking ratios post shocks are shown below:

Fig 20 Post Shock Banking Ratios

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