PART III. The Macro-financial Approach

Transcription

1 PART III The Macro-financial Approach

2

3 CHAPTER 28 Introduction to the Macro-financial Approach to Stress Testing ANDREA M. MAECHLER During the global fi nancial crisis, the world witnessed the near collapse of major financial institutions that many had believed to be impervious to the sort of panic that brought the global financial system to its knees and led to a worldwide recession. A key lesson from these events is that a purely microprudential approach to financial regulation and supervision, focused on the conditions of individual financial institutions and markets, could fail to detect important systemic or crosscutting risks (Bernanke, 2011). Since then, there has been a generalized push globally to make the financial sector as a whole more robust by taking a broader macro- financial approach to oversight. The key feature of such an approach is to recognize that fi nancial stability depends not only on the safety and soundness of individual financial institutions but also on how they interact with each other and with the real economy. A macrofinancial approach to financial oversight requires a holistic understanding of the sources of systemic risk. This includes monitoring the inherently procyclical nature of risk buildups (e.g., through leverage and rising asset prices), both in significantly important financial institutions and within the financial system more generally. 1 It also means assessing risk correlations among individual market participants and understanding how they may be interlinked with other market participants. Finally, there is a need to explicitly incorporate macrofinancial linkages in countries financial oversight frameworks, something that was poorly done before the global financial crisis (Bernanke, 2011). In this regard, macrofi nancial stress tests have proven particularly useful in overcoming key shortcomings in tradi- 1 See, for example, Adrian and Shin (2008) on how leveraged investment can fuel an asset and/or credit bubble. tional fi nancial supervision. They have provided a consistent framework for assessing fi rms common exposures to a set of risks. Moreover, by linking key projected macroeconomic and financial variables to firms per for mance, they have also helped to improve the understanding of how shocks are transmitted through the financial system to the real economy and to provide a forward- looking assessment of fi nancial stability. Although not new, macro- financial stress tests have gained prominence over the last few years. Macro- fi nancial stress tests have been an integral part of the IMF s Financial Sector Assessment Program (FSAP) since the late 1990s, although they typically were not integrated into countries regular surveillance framework (Moretti, Stolz, and Swinburne, 2008). One noteworthy exception is the Bank of En gland, which has been implementing macrofinancial stress tests since the early 2000s (Bunn, Cunningham, and Drehmann, 2005). In 2009, the U.S. authorities applied macro- financial stress tests under the Supervisory Capital Assessment Program (SCAP) to assess how much capital their largest bank holding companies needed to absorb potential losses and meet the needs of creditworthy borrowers under a more adverse scenario (Board of Governors of the Federal Reserve System, 2009a, 2011). In Eu rope, macrofinancial stress tests were used to assess banks capital adequacy in the context of the sovereign debt crisis. At the IMF, they were used to conduct a regular capital shortfall exercise that would feed into their global financial stability assessment (IMF, 2008a, 2008b, 2009a, 2009b, 2010a). A stylized macrofinancial stress test framework is presented in Figure 28.1 (see Bunn, Cunningham, and Drehmann, 2005; Jenkinson, 2008; and Constâncio, 2011, for discussions on macro- financial stress testing frameworks).

4 450 Introduction to the Macrofinancial Approach to Stress Testing Macro-financial context Firm-specific response Collective market feedback response Interlinkages/ default dependencies Shocks Macro-financial Scenario Risk exposures (credit risk, market risk, ) Firm Losses Firm Profits Asset-Side (market liquidity risk) Liability-Side (funding liquidity risk) Network/ Contagion Effects Firm Capital Feedback to macroeconomy ( financial accelerator effect) Source: Author. Figure 28.1 A Stylized Macrofinancial Stress Test Framework There are two stages to the pro cess: In the first stage, an initial shock needs to be translated into a macro- financial scenario that maps the projection of key macroeconomic and fi nancial variables (e.g., GDP, potential output, unemployment, house prices, bond yields). For example, market fears about an unsustainable fiscal position could result in higher sovereign yields, which could lead to a dampening in aggregate demand, higher unemployment, and lower potential output. This type of translation can be done using a variety of tools, ranging from largescale in- house macroeconomic models (e.g., structural macroeconomic models, dynamic stochastic general equilibrium models) to smaller partial equilibrium time series models and vector autoregressive- driven impulse response functions. In the second stage, the macro- financial scenario must be translated into fi rms fi nancial conditions (e.g., firm losses and earnings potential). In an accounting world, this is done by mapping the shock onto firms balance sheet exposures. In a risk- based world, part of the adjustment takes place through changes in financial firms risk profi les (e.g., probability of default, loss given default, credit ratings). Market price based risk approaches, including some of those presented in Part II of this volume, have the advantage of computing the distribution of possible outcomes, rather than single point estimates. The strength of macro- financial stress tests is to produce a consistent set of impact assessments, although each bank will show a different vulnerability depending on its own risk exposures: Credit risk models are the most developed. They can be based on accounting data or on more detailed portfolio- based or market- based data. Models linking nonperforming loans to macroeconomic variables are presented in Vazquez, Tabak, and Souto (Chapter 29) and Wezel, Canta, and Luy (Chapter 30). Sevogiano and Padilla (Chapter 31) present methodologies that incorporate the effects of macroeconomic shocks into credit risk, providing robust estimators when only short time series of loans exist and when only partial information about borrowers is available. Market risk models, on the other hand, are still largely in their infancy. Different approaches have been used to capture market risk. The IMF s U.S. FSAP capital shortfall exercise (IMF, 2010b), for example, focused on modeling the marked- to- market repricing of structured products (e.g., asset- backed securities, including mortgage- backed securities, credit default obligations). Among the high- profi le stress testing exercises, the Eu ro pe an Banking Authority stress test applied a fi xed haircut to specific sovereign paper, while the U.S. SCAP exercise conducted a separate test to stress banks trading book. Another challenge is to model the amplification of systemic risk through network effects. A severe strain at, or even default in, a systemically important financial institution, for example, is likely to affect the soundness of similar firms. This requires accounting for the inherently nonlinear nature of fi nancial

5 Andrea M. Maechler 451 instability, where risk correlations can rise sharply in tail- risk scenarios. Promising work has been done in the area, including the approaches presented by Segoviano and Goodhart in Chapter 32 and by Jobst and Gray earlier in Chapter 26, where the entire nonparametric time- varying dependence structure among financial institutions is derived. Nonetheless, much remains to be done to fully integrate high- frequency, market- based approaches into the more traditional and slowmoving macroeconomic models. Most macro- fi nancial stress tests focus on the first- round effects, namely, on financial firms ability to absorb an adverse shock and provide credit to the economy. The impacts of severe macro shocks typically are modeled as if they occur on a one- off basis, leading to an underestimation of the possible impacts. The macro- financial shock is then mapped onto firms capital needs and credit growth potential. One example is the forward- looking balance sheet approach, such as the one used in the U.S. SCAP exercise and presented in a simplified fashion by Keim and Maechler in Chapter 33, which models the impact of a projected path for key macroeconomic and financial variables on banks capital buffers and other balance sheet positions, including their ability to provide credit. The crisis also has highlighted the challenge of aggregating risk factors across individual institutions and modeling fi rms profitability (see Board of Governors of the Federal Reserve System, 2009b), with stress testing revenues especially for stressed conditions largely seen to be a black box (Schuermann, 2012). Thus, one of the biggest challenges for stress testing is to adequately model the systemic impact of a par tic u lar shock, taking into account the full cycle of macroeconomic and financial interactions and feedback effects. Individual bank responses to a given shock can lead to a broader market response, with further feedback effects to banks exposures. For example, a slowdown in issuance or a pullback of credit by banks following an initial economic or market shock could further affect economic activity (second- round effect), which would have implications for the banks ability to additionally absorb the consequences of further deterioration in the macroeconomic environment (third- round effect) and so forth. This requires macroeconomic models with richer real- financial linkages, something that largely was lacking prior to the global financial crisis (Roger and Vlcek, 2011). Tieman and Maechler (Chapter 34) take a step toward closing this gap in the literature by estimating the short- run feedback effects from financial sector risk to the real economy through the credit channel. REFERENCES Adrian, Tobias, and Hyun Song Shin, 2008, Financial Intermediaries, Financial Stability, and Monetary Policy, FRBNY Staff Report No. 346 (New York: Federal Reserve Bank of New York). Available via the Internet: /research /staff _reports /sr346.html Bernanke, Ben S., 2011, Implementing a Macroprudential Approach to Supervision and Regulation, Remarks at the Federal Reserve Bank of Chicago, 47th Annual Conference on Bank Structure and Competition, Chicago, May 5. Available via the Internet: /newsevents /speech /bernanke a.htm Board of Governors of the Federal Reserve System, 2009a, The Supervisory Capital Assessment Program: Design and Implementation (Washington, April 24). Available via the Internet: /bankinforeg /scap.htm, 2009b, The Supervisory Capital Assessment Program: Overview of Results (Washington, May 7). Available via the Internet: /bankinforeg /scap.htm, 2011, Comprehensive Capital Analysis and Review: Objectives and Overview (Washington, March 18). Available via the Internet: /newsevents /press /bcreg /bcreg a1.pdf Bunn, Philip, Alastair Cunningham, and Mathias Drehmann, 2005, Stress Testing as a Tool for Assessing Systemic Risks, Financial Stability Review, June, pp (London: Bank of En gland). Available via the Internet: /pub lications /Pages /fsr /2005 /fsr18.aspx Constâncio, Vitor, 2011, Macro- Prudential Policy: Strengthening the Foundations Enhancing the Toolkit and Taking Action, keynote address at the First Conference of the Macro- Prudential Research Network, Frankfurt, October 5. Available via the Internet: /press /key /date /2011 /html /sp en.html International Monetary Fund, 2008a, Global Financial Stability Report, World Economic and Financial Surveys (Washington, April). Available via the Internet: /External /Pubs /FT /GFSR /2008 /01 /index.htm, 2008b, Global Financial Stability Report, World Economic and Financial Surveys (Washington, October). Available via the Internet: /external /pubs /ft /gfsr /2008 /02 /index.htm, 2009a, Global Financial Stability Report, World Economic and Financial Surveys (Washington, April)., 2009b, Global Financial Stability Report, World Economic and Financial Surveys (Washington, October)., 2010a, Global Financial Stability Report, World Economic and Financial Surveys, (Washington, April)., 2010b, United States: Stress Testing Technical Note, IMF Country Report 10/244 (Washington, July). Available via the Internet: /external /pubs /cat /longres.aspx?sk=24101 Jenkinson, Nigel, 2008, Developing a Framework for Stress Testing of Financial Stability Risks, comments to the ECB High Level Conference on Simulating Financial Instability, Frankfurt, July Available via the Internet: /review / r070716g.pdf Moretti, Marina, Stephanie Stolz, and Mark Swinburne, 2008, Stress Testing at the IMF, IMF Working Paper 08/206 (Washington: International Monetary Fund). Available via the Internet: /external /pubs /cat /longres.aspx?sk=22275 Roger, Scott, and Jan Vlcek, 2011, Macro- Financial Modeling at Central Banks: Recent Developments and Future Directions, IMF Working Paper 11/103 (Washington: International Monetary Fund). Available via the Internet: /ex ternal /pubs /cat /longres.aspx?sk=24829 Schuermann, Til, 2012, Stress Testing Banks, Wharton Financial Institutions Center Working Paper No (Philadelphia: University of Pennsylvania).

6