Tuesday, January 6, 2015

Testing the Soundness of Banks

The global financial crisis placed a spotlight on the stress testing of financial systems. Although weaknesses in stress tests were exposed by the devastating 2007-09 crisis, the recent experience of several countries has conversely provided a stark illustration of their potential benefit in examining the resilience of bank balance sheets when performed credibly and transparently. Nonetheless, the large menu of stress testing approaches, methods, and models raises questions about their appropriate application under different situations and, consequently, the comparability and reliability of the associated analyses.

The International Monetary Fund has had a long and detailed involvement in the stress testing of financial systems. Since the introduction of its Financial Sector Assessment Program more than a decade ago, IMF staff have conducted stress tests of banking sectors in over 120 countries, typically in close collaboration with country authorities.

Stress testing is also playing an increasingly important role in the IMF’s multilateral economic surveillance, through the analysis in its Global Financial Stability Report. Separately, member countries are increasingly requesting IMF technical assistance in stress testing as they develop their own expertise in this area. As a result, IMF economists have amassed a wealth of hands-on experience with stress testing techniques and their practical application.

Compendium of models

This book represents a compendium of stress testing methods, models, and tools developed or adapted by IMF staff over the years. Almost all the methods and models that are included in this volume have, at one time or another, been applied in its surveillance of, or technical assistance to, member countries. To guide users, each chapter offers a summary describing the application of a method or model, its strengths and weaknesses, and the data requirements. Where available, the stress testing tools or program codes are also provided for wider public use.

Although this volume will provide a valuable resource for policymakers, supervisors, academics, and private sector participants alike, caveats still apply. The crisis has underscored that stress tests, irrespective of their level of sophistication, are not fail-safe, stand-alone diagnostic tools.

Assessments of the soundness of any financial system cannot and should not be based solely on a “model” and must be complemented by other quantitative analyses, qualitative information, and, most important, expert judgment. Especially in light of evolving market practices, risks, and regulatory requirements, stress testing will necessarily continue to be art rather than science.

Ongoing work

Jose Vinals, head of the IMF's Monetary and Capital Markets Departments, says in a Foreword IMF staff are continually working to strengthen the analytical underpinnings of its stress testing, in ways that will help bolster its consistency and comparability and hence its credibility.

Key areas of focus, according to Vinals, include extending the analysis to better cover nonbank financial institutions and infrastructures; to take account of spillovers between institutions and across borders; to consider the interaction between liquidity and solvency risks; and to address data gaps. In addition, IMF economists are developing the policy-related aspects of stress testing, namely, “best practice” principles, concepts, and frameworks, to complement and strengthen the application of the models. "These efforts represent a challenging and exciting part of the IMF’s broader support of global efforts to improve financial surveillance and promote sound macroprudential frameworks," Vinals writes.

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