Top-Down Stress Testing: Key Results
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
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
References: Basel Committee on Banking Supervision, (1999) ‘‘Sound Practices for Loan Accounting and Disclosures’’, mimeo, Bank for International Settlements. Blaschke, W., M.T. Jones, G. Majnoni and S.M. Peria, (2001) ‘‘Stress Testing of Financial Systems: An Overview of Issues, Methodologies, and FSAP Experiences’’, Working Paper, No. WP/01/88, International Monetary Fund. ˘ ´ Cihak, M., (2004) ‘‘Designing Stress Tests for the Czech Banking System’’, International Research and Policy Note, No. 3, Czech National Bank. IMF/World Bank, (2003) ‘‘Analytical Tools of the FSAP’’, mimeo, International Monetary Fund. Jones, M.T., P. Hilbers and G. Slack, (2004) ‘‘Stress Testing Financial Systems: What To Do When The Governor Calls’’, Working Paper, No. WP/04/127, International Monetary Fund. Kearns, A., (2003a) ‘‘Mortgage Arrears in the 1990s: Lessons for Today’’, Quarterly Bulletin, Autumn 2003, CBFSAI. Kearns, A., (2003b) ‘‘Corporate Indebtedness and Liquidations in Ireland’’, Quarterly Bulletin, Summer 2003, CBFSAI. Kearns, A., (2004) ‘‘Loan losses and the Macroeconomy: A Framework for Stress Testing Irish Credit Institutions’ Financial Well-being’’, Financial Stability Report, 111-121, CBFSAI. Sorge, M., (2004) ‘‘Stress-Testing Financial Systems: An Overview of Current Methodologies’’, Working Paper, No. 165, Bank for International Settlements. Financial Stability Report 2006 111