Macro prudential stress testing: Monitoring the financial system Pt.2

By Riccardo Tedeschi | 31 October 2017

EU-wide stress tests of the EBA chiefly represent a micro prudential and severe assessment of the solvency of the individual banks monitored by the ECB, useful for preventive actions in specific situations. This is an extremely useful test, although insufficient per se from the perspective of the supervisory authorities.

As explained exhaustively by the Vice-President of the ECB, Vítor ConstaÌ‚ncio, in a speech given at the London School of Economics in October 2015 on the role of stress testing and macro prudential  policy, from the viewpoint of those having to make economic and financial policy decisions aimed at monitoring and limiting the so-called “systemic risk”, this test presents an assortment of limits.

Systemic risk is defined by the ECB itself as “the risk that financial instability may significantly damage the supply of financial products and services by the banks and financial institutions to such an extent that economic growth and general welfare might be seriously affected” (ECB Financial Stability Review December 2009, Special Features B). The basic idea is that financial crises imply considerable costs for the real economy; therefore, the supervisory authorities should do their utmost to prevent them.

There are essentially three key “sources” of systemic risk: macroeconomic shocks on aggregate demand or supply; imbalances stemming from public or private over-indebtedness; contagion risks resulting from high levels of interconnection and “herding behaviour”.

The macro prudential policies adopted by central banks pursue myriad objectives along diverse dimensions:

  • time dimension: to prevent an excessive accumulation of risks, stemming both from external factors as well as from any potential market failures, and to smooth the fluctuations over the financial cycle;
  • transversal dimension: to render the financial sector more resilient to shocks and to limit contagion effects;
  • structural dimension: to encourage the use of a broad perspective at system level in financial regulations for market operators in order to create a set of correct incentives for market participants.

 

Examples of macro prudential decisions include the variation in the so-called “capital buffers”, the additional layers of minimum capital that banks must hold in a specific period. Alternatively, the introduction of binding rules in the allocation of funding such as a ceiling for the ratio between the mortgage on a property and its value, namely the loan-to-value ratio.

In financial literature since 2008, various ratios have been proposed for measuring the current level of system risk, as well as the marginal contribution of each individual financial institution to the overall systemic risk. Nevertheless, from the standpoint of the supervisory authorities, none of the indicators suggested so far has proved useful, in practical terms, to guide the decisions for intervention on the financial system in order to prevent crises from forming or to guide it out the “quicksand” of an existing crisis.

For this reason, the ECB has decided to invest in the development of a set of its own “upgraded” macro prudential models that leverage the set of data and instruments used for micro prudential stress testing on the solvency of banks. The approach employed by the ECB and the set of instruments developed, “Stress-Test Analytics for Macro prudential Purposes in the Euro area” (STAMP€), is outlined in detail in a publication dated February 2017.

What are the characteristics of this new approach?

Based on the adverse scenario, identified as a potential “threat” to the stability of the financial system, the balance sheets of the individual financial institutions are simulated as in the EBA EU-wide stress tests. This time, however, the top-down and dynamic balance sheet approach is used.

Whereas in the EBA micro prudential stress testing no adjustment by the bank's management of the adverse scenario is permitted in any way, in this type of simulation conducted independently by the ECB, the possibility of dynamic adjustment by the management to the variations in the macroeconomic framework or to the actions of the supervisory authorities is introduced.

Banks may react in various ways: deleveraging their riskiest activities, proceeding with capital increases, if the conditions of the stock market so allow, or accelerating the recovery of non-performing loans also via transfers. A combination of the various alternatives is also feasible.

The impact resulting at system level shall differ according to the behaviour most pursued by the individual banks. For instance, let us assume that, following a slowdown in the economic cycle and a subsequent increase in the capital ratios imposed by the supervisory authorities (or required autonomously by the market), banks react by reducing the loans granted to their customers, specifically those considered the riskiest. In so doing, the credit rationing to the economy would trigger a vicious circle that could engender a recession even more severe than the one originally conceived.

Figure 3 - The structure of the ECB modules for the top-down analysis of the solvency of the banks

Source: ECB, publication STAMP€ feb. 2017, chapter 2​

 The behaviour of the individual banks is simulated via models for the re-composition of loans and their collection, based on criteria for optimising the risk/return profile. The results of the simulations conducted by the ECB tend to confirm the widespread opinion that in response to negative shocks entailing a deterioration of the credit risk and tight constraints on collection, banks tend to divest assets as opposed to proceed with increases in capital and maintain the existing leverage.

Once the reactions of the banks has been defined, it is crucial in macro prudential terms to grasp the interconnection between financial economy and real economy. To this end, the ECB uses two different macroeconomic models (The first is a Dynamic Stochastic General Equilibrium (DSGE) model and the second is a Global Vector Autoregressive (GVaR) model), tailored to each individual European country, that adopt the behaviour hypotheses of the banks and allow for the development of the subsequent impacts on GDP, consumption and investment, and different spillovers across the diverse economies.

For instance, in Figure 4 illustrates the aggregate impact (estimated on 2013 data) on the CET1 capital ratio of a stress test in different cases: static, at variable trends, with dynamic managerial actions, with macroeconomic feedback.

Figure 4 – Macroeconomic feedback effects of the financial economy on the real economy in the STAMP€ System

Source: ECB, publication STAMP€ feb. 2017, chapter 2

Another significant limit of micro prudential EBA EU-wide stress testing is represented by the complete lack of controls on the so-called “second round effects”.

An important source of second round effects that should not be overlooked stems from the high degree of interconnection across banks, which may entail contagion effects able to amplify the initial effects of a financial shock. For instance, the insolvency of a bank may bring about losses for other strongly exposed financial intermediaries. To properly address the dependencies that interbank deposits and derivative contracts imply across banks, especially those of greater systemic proportions, representation models archetypal in the analysis of social networks have been developed (network analysis). Such models make it possible to know in advance, given the existing connection network, where and how the shock wave caused by the failure of a bank would have a more significant impact (financial contagion).

A further extension of the simulations of micro prudential stress testing is to consider the interactions between the banking sector and the rest of the economy, from households and enterprises to other non-bank financial institutions. In order to take into account in an increasingly realistic manner the second round effects, the ECB has introduced among its instruments new models that appraise such interactions.

For instance, a household-specific modelling has been developed (Integrated Dynamic Household Balance Sheet (IDHBS) model of the euro area household sector) based on the results of an array of sample surveys on household budgets (Household Finance and Consumption Survey) and extended to 15 European countries, to obtain a projection and an independent estimate of the demand for credit and of the probability of default of the private sector, specifically in the residential mortgage segment. The possibility of submitting household budgets to stress testing is especially relevant in macro prudential terms, to guide the supervisory authorities in imposing caps to indicators such as loan-to-value, debt-to-income and debt-service-to-income. The imposition of caps to such indicators in granting bank credit indeed affects the actual demand for mortgage loans by households, the level of debt of the economy and, accordingly, the entire evolution of the financial and economic cycle.

Phenomena of diffusion of a crisis may also spring from the plain loss of value of equity securities issued by banks, such as shares or bonds, on the portfolios of other financial institutions. Specialised models have been developed for the simulation and stress testing of balance sheets of non-bank financial segments: insurance companies, pension funds and social fund schemes, investment funds and other financial institutions (that constitute the so-called “shadow banking system”).

Lastly, explicit macro liquidity stress tests have been introduced that attempt to grasp in macro terms the two dimensions of the issue: the correlation between liquidity and solvency at the level of the individual bank and the repercussions of a liquidity crisis on the financial system in its entirety.

Figure 5 displays an overview briefly summarising the various instruments making up the new system of the ECB because of the macro prudential extension of stress testing.

Figure 5 - Structure of the macro prudential extension of the EBA monitoring stress tests.

Source: ECB, publication STAMP€ Feb. 2017, chapter 3

Those responsible for the macro prudential tests of the ECB describe STAMP€ as an evolving, complex system, indicating its development and optimisation guidelines. This fascinating challenge shall pave the way for new paths and new questions. No doubt, it represents a step forward in understanding complex economic and financial systems.

The American economist John Kenneth Galbraith, in the final part of his book “A History of Economics” (1987), on the topic of future developments in economic theory, predicted that in future: “The distinction between microeconomics and macroeconomics will blur and disappear”. With the evolution of the instruments and techniques of macro prudential stress testing, this time is fast approaching.