Featured Product

    IMF Paper on Sovereign Risk in Macroprudential Solvency Stress Testing

    December 06, 2019

    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 LinkWorking Paper

    Keywords: International, Banking, Stress Testing, FSAP, Sovereign Risk, Systemic Risk, Credit Risk, Macro-prudential Stress Test, IMF

    Featured Experts
    Related Articles
    News

    EBA Launches Stress Tests for Banks, Issues Other Updates

    The European Banking Authority (EBA) launched the 2023 European Union (EU)-wide stress test, published annual reports on minimum requirement for own funds and eligible liabilities (MREL) and high earners with data as of December 2021.

    January 31, 2023 WebPage Regulatory News
    News

    EBA Proposes Standards for IRRBB Reporting Under Basel Framework

    The European Banking Authority (EBA) proposed implementing technical standards on the interest rate risk in the banking book (IRRBB) reporting requirements, with the comment period ending on May 02, 2023.

    January 31, 2023 WebPage Regulatory News
    News

    FED Issues Further Details on Pilot Climate Scenario Analysis Exercise

    The U.S. Federal Reserve Board (FED) set out details of the pilot climate scenario analysis exercise to be conducted among the six largest U.S. bank holding companies.

    January 17, 2023 WebPage Regulatory News
    News

    US Agencies Issue Several Regulatory and Reporting Updates

    The Board of Governors of the Federal Reserve System (FED) adopted the final rule on Adjustable Interest Rate (LIBOR) Act.

    January 04, 2023 WebPage Regulatory News
    News

    ECB Issues Multiple Reports and Regulatory Updates for Banks

    The European Central Bank (ECB) published an updated list of supervised entities, a report on the supervision of less significant institutions (LSIs), a statement on macro-prudential policy.

    January 01, 2023 WebPage Regulatory News
    News

    HKMA Keeps List of D-SIBs Unchanged, Makes Other Announcements

    The Hong Kong Monetary Authority (HKMA) published a circular on the prudential treatment of crypto-asset exposures, an update on the status of transition to new interest rate benchmarks.

    December 30, 2022 WebPage Regulatory News
    News

    EU Issues FAQs on Taxonomy Regulation, Rules Under CRD, FICOD and SFDR

    The European Commission (EC) adopted the standards addressing supervisory reporting of risk concentrations and intra-group transactions, benchmarking of internal approaches, and authorization of credit institutions.

    December 29, 2022 WebPage Regulatory News
    News

    CBIRC Revises Measures on Corporate Governance Supervision

    The China Banking and Insurance Regulatory Commission (CBIRC) issued rules to manage the risk of off-balance sheet business of commercial banks and rules on corporate governance of financial institutions.

    December 29, 2022 WebPage Regulatory News
    News

    HKMA Publications Address Sustainability Issues in Financial Sector

    The Hong Kong Monetary Authority (HKMA) made announcements to address sustainability issues in the financial sector.

    December 23, 2022 WebPage Regulatory News
    News

    EBA Updates Address Basel and NPL Requirements for Banks

    The European Banking Authority (EBA) published regulatory standards on identification of a group of connected clients (GCC) as well as updated the lists of identified financial conglomerates.

    December 22, 2022 WebPage Regulatory News
    RESULTS 1 - 10 OF 8700