Top-Down Stress Testing: Key Results

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  • Published : April 9, 2011
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Top-Down Stress Testing: The Key Results
by Allan Kearns1
ABSTRACT The CBFSAI’s overall assessment of the resilience of the banking sector to adverse shocks relies on both an analysis of the current health of the sector as well as stress testing the system. A stress test is generally an investigation whereby a bank’s or group of banks’ current financial health is stressed by adverse shocks and the impact of these shocks on the institutions’ financial position is quantified. This paper outlines the key results from top-down stress tests on the Irish banking sector. The top-down stress test documented in this paper is an approach where the tests are conducted in-house (i.e., by a central bank or financial regulator and without the participation of the credit institutions) and the results for individual credit institutions are aggregated to reflect the banking sector as a whole. Notwithstanding some noteworthy limitations of the stress-test analysis and qualifications to the results, the overall results are positive and are supportive of the CBFSAI’s overall assessment that the banking system’s shock-absorption capacity appears strong. These results also complement the bottom-up test which is documented elsewhere in this Report.

1. Introduction
This paper outlines the key results from top-down stress tests on the Irish banking sector. A stress test is generally an investigation whereby a bank’s or group of banks’ current financial health is stressed by adverse shocks and the impact of these shocks on the institutions’ financial position is quantified. There are several ways to conduct stress tests. The approach in this paper is closest to the top-down approach where the tests are conducted inhouse (i.e., by a central bank or financial regulator and without the participation of the credit institutions) and the results for individual credit institutions are aggregated to reflect the banking sector as a whole.2 There is a large and growing literature on stress-testing national financial systems.3 All of the stress tests documented in this paper gauge the banking sector’s ability to afford a range of losses, generated under a variety of hypothetical scenarios. The losses are assumed to be taken entirely out of the banks’ capital reserves under the conservative assumption that there are no profits or other reserves to contribute towards the losses. The paper uses prudential data collected by the Financial Regulator and supplements this with data from the institutions’ annual accounts or the Central Bank’s money and banking statistics. The 1

emphasis in this paper is on those institutions that appear to be of greatest relevance from an Irish financial stability perspective. Our sample of banks comprises a set of eleven retail credit institutions, namely, those banks dealing directly with Irish resident households, corporates and other retail credit institutions.4 Consolidated prudential data, which include both domestic and international operations of these banks, are used whenever available. Finally, the aggregate data on individual credit institutions are usually weighted by each bank’s size (proxied by the value of their total assets) in an attempt to reflect more accurately the aggregate banking sector. This approach reduces the impact of the smaller credit institutions on the overall results. The structure of the paper is as follows. Sections 2 to 6 document each of five significant risks in turn: credit risk, liquidity risk, foreign-exchange risk, interest-rate risk and equity risk. Within each section, the nature of the risk is explained in a qualitative way and the exposure of the Irish banking sector to this risk is quantified. This is followed by a brief description of the various stress tests used internationally by the IMF and other central banks/supervisory agencies to assess the robustness of an institution or banking system to a realisation of that particular risk. Each section concludes with the results...
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