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Cross-Border Issues in Stress-Testing Jan Willem van den End De Nederlandsche Bank Paper presented at the Expert Forum on Advanced Techniques on Stress Testing: Applications for Supervisors Hosted by the International Monetary Fund Washington, DC– May 2-3, 2006 The views expressed in this paper are those of the author(s) only, and the presence of them, or of links to them, on the IMF website does not imply that the IMF, its Executive Board, or its management endorses or shares the views expressed in the paper. Cross-Border Issues in Stress-Testing IMF Expert Forum on Advanced Techniques on Stress-Testing Washinghton DC, 2-3 May 2006 Jan Willem van den End (w.a.van.den.end@dnb.nl) Outline z Cross-border issues o where do we stand o concepts and evidence of risks and contagion z Macro stress-testing cross-border risks by DNB o scenarios o liquidity risk o group-wide approach 1. Increased financial integration ¾ Internationalization financial markets ¾ Globalisation financial institutions ¾ Cross-border payments systems ¾ Consolidation exchanges and clearing and settlement systems 2. Financial integration: evidence 0 100 200 300 400 Bon ds Equ itie s B on ds E qu itie s B on ds E qu itie s 1975-79 1980-1984 1985-89 1990-94 1995-1999 2000 2001 2002 Cross-border transactions in bonds and equity Per cent of GDP, source: BIS US Japan Germany 3. CB risks in macro-prudential analysis “there is still insufficient attention in many FSAPs to global and regional linkages” (IMF IEO, 2005) Results of the IEO assessments of FSAP content1 Criteria Mean score (on scale of 1- 4) Percentage of ratings indicating some problems Extent of incorporation of regional /global risks into analysis 1.84 28 Balance of development and stability issues 1.88 16 Integration of standard and codes in overall assessment 1.84 20 Coverage of overall financial sector 2 20 Clarity and candor of findings 1.88 12 Importance and consequence well explained 1.94 20 Clarity of recommendations 1.82 8 Usability of recommendations 1.96 16 Prioritisation of recommendations 2.46 44 Degree of alignment of FSAP and FSSA 1.42 0 1 IEO assessors rated each of the FSAPs for the 25 countries in depth with respect to the above criteria. Each aspect was rated on a four point scale (with 1 being the highest). source: IMF 4. Cross-border risks and contagion Concepts of systemic risk (De Bandt and Hartmann, 2000) z idiosyncratic: domino effects from single failure z systematic: simultaneous effects from widespread shock Cross-border propagation mechanisms z direct contagion (cross-border balance sheet linkages: interbank contagion models) z indirect contagion (exogenous global shock: global risk scenarios) 5. Direct contagion: evidence Between institutions ¾ Research: support for interbank market as important contagion channel (Gropp and Vesala, 2004 / Hartmann et al, 2005) Within financial groups ¾ Joint Forum: LCFIs face cross-border liquidity risk ¾ Dutch bank: dry run revealed forex complication 6. Indirect contagion: historical evidence Global financial system as mechanism for transmission and amplification of shocks ¾ Historical scenarios: 1987 stock market, 1994 bond market, 1998 emerging markets /LTCM, 2005 credit derivative market Typical features ¾ Interaction global risk factors ¾ Key role liquidity (hard to internalise in micro stress-tests) 7. CB issues in the Netherlands Cross-border issues highly relevant ¾ small open economy ¾ internationally integrated financial system ¾ LCFIs and large institutional investors (IC, PF) 0 25 50 75 98 99 00 01 02 03 04 Residents Nonresidents Cross border assets insurance companies and pension funds In percentage of total assets Source: DNB. 0 10 20 30 40 50 98 99 00 01 02 03 04 Dutch banks: non-Dutch contributions to profits In percentage of total profits Source: DNB. 8. DNB well positioned for CB issues Systemic stability non-securities securities Banks A F Securities M Insurance pensionfunds DNB = De Nederlandsche Bank AFM = Authority for Financial Markets Prudential Conduct of business DNB 9. Macro stress-testing by DNB DNB’s macro stress-testing framework is combination of bottom-up and top-down methods ● Bottom-up o regular exercise including banks, PF and IC o DNB designs scenarios and instructs institutions, they run their internal models, DNB aggregates the results ● Top-down o credit and interest rate risk of banks (reduced form models) o interbank risk (interbank contagion model) o market risks PF/IC (structural models) 10. Stress-testing cross-border issues Three ways to address cross-border issues in stress-tests ¾ scenario design (systemic shock ⇒ indirect contagion) ¾ liquidity risk, key role (systemic and idiosyncratic shocks ⇒ indirect and direct contagion) ¾ group-wide approach 11. Global risk drivers in scenarios Scenario analyses DNB (Overview of Financial Stability in the Netherlands, OFS) ¾ tool for macro-prudential monitoring ¾ hypothetical macro scenarios modelled by macro economic model ¾ global factors main risk drivers ¾ interaction of global risk factors over multi-year horizon 12. CB transmission in macro scenarios In the recent macro scenarios of DNB… ¾ Malaise ¾ Global correction …the transmission to the domestic system mainly runs through international interest rate movements Global correction scenario affects financial sector: ¾ Financial contagion ⇒ market risk (worldwide rise of risk aversion, declining asset prices, currency losses on foreign assets) ¾ Transmission to economy by wealth effects and trading channel ⇒ credit risk 13. Impact macro scenarios on banks Banks most vulnerable for global correction scenario (worldwide exposures) 0 1 2 3 4 5 6 0 1200 2400 3600 4800 6000 7200 8400 9600 Base scenario Malaise scenario European malaise: impact on total credit portfolio Probability distribution of credit losses, horizon 3 yrs 0 1 2 3 4 5 6 0 1200 2400 3600 4800 6000 7200 8400 9600 10800 Base scenario Global correction Global correction: impact on total credit portfolio Probability distribution of credit losses, horizon 3 yrs 14. Impact macro scenarios on PF IC, PF most vulnerable for European malaise scenario (interest rate sensitivity due to negative duration gap) 85 95 105 115 125 135 145 155 2 2,5 3 3,5 4 4,5 5 5,5 6 Base scenario Malaise scenario Global correction scenario Funding ratio of pension funds in scenarios Funding ratio, per cent, with shocks in interest rate and stock price index according to scenarios (effects after 3 years) Explanation: the lines "Malaise" and "Base scenario" nearly coincide and show that the impact of a positive stock market shock coincides in both scenarios. The line "Global correction" shows the impact of various interest rates at the negative stock market shock in this scenario. Source: DNB. Required minimum Required surplus Base scenario Malaise Global correction funding ratio 15. Liquidity risk in stress-testing Liquidity risk hard to model… …but key in systemic risk Liquidity risk of banks addressed by ¾ scenarios for bottom-up stress-testing ¾ interbank contagion model ¾ liquidity supervision at the level of the institutions (also based on scenarios) 16. Global liquidity scenario Liquidity scenario in bottom-up stress-tests of DNB Market crisis (systemic shock)… ¾ drying up interbank market euro area ¾ shut down CD, CP market ¾ falling asset prices, rising interest rates and spreads …options: outright sales of assets, posing additional collateral at central bank Indicators ¾ liq assets / liq liabilites ratio ¾ time to default 17. DNB interbank contagion model DNB interbank model to test direct contagion of idiosyncratic shock (top-down) Conclusions simulation ¾ main risks for Dutch banks have cross-border nature (losses from foreign regions have stronger impact than failure of other Dutch banks). Due to global nature of banks exposures ¾ In particular foreign subsidiaries and/or branches are vulnerable to shocks originating in the parent company region 18. Liquidity supervision DNB’s liquidity risk supervision ¾ Stress-test based tool (scenario mix) ¾ fixed weights for hair cuts on assets and withdrawal rate of liabilities ¾ useful for macro prudential analysis Liquidity position based on stressed conditions Monthly period Average surplus ratio * Average surplus as % of average liquidity requirement (average over the period 06/03 - 09/03) 0 5 10 15 20 25 -30-00-1010-2020-3030-4040-5050-100100-150150-200>200Average surplus ratio* Number of banks 19. Importance group-wide approach Group-wide approach of stress-tests, covering both domestic and foreign activities (LCFIs with cross-border operations)... …to capture risks and identify potential spill-overs among business areas within the group 20. Group-wide approach DNB (1) Liquidity supervision ¾ group-wide reporting of liquidity data, incl. material branches and subsidiaries abroad ¾ Inclusion of liquidity surplusses abroad only permitted if no liquidity deficit in foreign entity and if convertible currency Bottom-up stress-testing ¾ reporting break-down of results by business unit 21. Group-wide approach DNB (2) Top-down stress-testing ¾ modelling consolidated balance sheets ¾ separate credit risk models for domestic vs. total exposures t 3 t 2 t 1 i t , i ) NL _ Defaulrate ( RL NL _ GDP effects fixed dom _ CRED dom _ LLP λ β β β λ + + + = ⎟⎟ ⎠ ⎞ ⎜⎜ ⎝ ⎛ t 3 t , i 2 t , i 1 i t , i ) world _ Defaulrate ( RL EU _ GDP effects fixed total _ CRED total _ LLP λ β β β λ + + + = ⎟⎟ ⎠ ⎞ ⎜⎜ ⎝ ⎛ 22. Cross-border approach ESCB ESCB/BSC/WGMA Task Force on Stress Testing to explore ways to extend macro stress-tests with cross-border inter-linkages Possibly by adding European dimension to national stress-tests 23. Conclusions z Cross-border risks important, but usually neglected in macro stress-tests z Cross-border issues could be incorporated by: o scenario analyses o focus on liquidity o group-wide approach Cross-Border Issues in Stress-Testing IMF Expert Forum on Advanced Techniques on Stress-Testing Washinghton DC, 2-3 May 2006 Jan Willem van den End (w.a.van.den.end@dnb.nl)
