IMF published a working paper that explains how to assess vulnerability of a bank to sovereign risk in macro-prudential solvency stress testing, based on experiences in the Financial Sector Assessment Program (FSAP). The paper discusses four aspects of the stress tests: scope of exposures and transmission channels, loss-estimation methods, shock calibration, and calculation of capital impact. IMF presented a flexible, closed-form approach to calibrating market-implied haircuts using the extreme value theory, EVT, to capture the impact of significant shocks to sovereign risk on bank solvency.
The main FSAP approach for stress testing sovereign risk has been to measure valuation effects on traded government debt caused by changes in expected default rather than actual default during adverse macroeconomic conditions. A sovereign risk shock is calibrated as the market-consistent haircut implied by the estimated decline in the fair value of government bonds (market valuation approach) using their price or yield volatility. This paper advances the existing approach toward a tractable method for the calibration of sovereign risk shocks as tail events. The paper is largely based on the experiences with stress testing of banks in the FSAP of IMF over the past decade. However, the same loss-estimation and calibration approach is, in principle, applicable to not only banks but also other types of financial institutions, such as insurance companies, pension funds, and asset managers.
The paper concludes that macro-prudential solvency stress tests, such as those in FSAPs, share the following common characteristics in assessing the capital impact of sovereign distress:
- It is ideal for covering all sovereign exposures in both the trading and banking books, for instance, by following the semi-annual Basel III monitoring exercises of BCBS, including indirect exposures that are either government-guaranteed or collateralized by instruments issued by sovereign entities.
- The market valuation approach provides a transparent capital assessment of sovereign risk. Applying this approach to all securities, including HtMsecurities, allows the most transparent and comparable assessment across banks and jurisdictions, though the treatment of HtM securities varied across FSAPs.
- Capital requirements for unexpected losses from local sovereign exposures are very low due to their status as “safe assets.” Stress tests typically maintain the prevailing capital intensity since the capital impact of revising the risk-weights for sovereign exposures is likely to be very large and policy discussions on reforming the current regulatory treatment are evolving.
- When stress is already ongoing, the latest market valuation could be even lower than the value reflected insolvency ratio for some exposures. Then, it is more transparent to separate deterioration of solvency ratio due to already materialized stress from additional stress in the adverse scenario.
- Where there are higher chances of outright sovereign default in economies where a large part of sovereign exposures are loans and guarantees (including state-owned enterprises), a more extensive range of macro-financial spillover effects become more important. Then, focusing on the valuation changes with sovereign securities may become too narrow. A more comprehensive approach, including an effort to embed them in a macro scenario is likely to be essential.
When calibrating the valuation haircuts for sovereign securities, the IMF approach underscores the importance of accounting for the tail-risk nature of sovereign risk. An integrated sovereign risk assessment for macro-prudential surveillance and financial stability analysis will require additional work. The market valuation approach focuses on the direct impact of sovereign distress on bank solvency but does not consider other transmission channels across sectors and countries. Such feedback effects can be assessed more comprehensively by either interacting sovereign debt sustainability analysis and bank stress tests or estimating the effects in empirical multi-sector models (such as Global Vector Autoregressive, or GVAR, approaches), co-dependence models for both banks and sovereigns, or general equilibrium models with bank and sovereign distress. In addition, the interaction between solvency and liquidity conditions under stress could be explicitly addressed as part of integrated stress testing frameworks that model dynamic and systemic effects from credit, market, and liquidity risks.
Related Link: Working Paper
Keywords: International, Banking, Stress Testing, FSAP, Sovereign Risk, Systemic Risk, Credit Risk, Macro-prudential Stress Test, IMF
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