Abstract
Credibility is the bedrock of any crisis stress test. The use of stress tests to manage systemic risk was introduced by the U.S. authorities in 2009 in the form of the Supervisory Capital Assessment Program. Since then, supervisory authorities in other jurisdictions have also conducted similar exercises. In some of those cases, the design and implementation of certain elements of the framework have been criticized for their lack of credibility. This paper proposes a set of guidelines for constructing an effective crisis stress test. It combines financial markets impact studies of previous exercises with relevant case study information gleaned from those experiences to identify the key elements and to formulate their appropriate design. Pertinent concepts, issues and nuances particular to crisis stress testing are also discussed. The findings may be useful for country authorities seeking to include stress tests in their crisis management arsenal, as well as for the design of crisis programs.
Highlights
Stress tests have become the “new normal” in financial crisis management
Sources: Bloomberg; and authors’ calculations; 1/ Relative to announcement of stress test results; 2/ The publication of the IMF’s Third Review in September 2011 indicating that the outcomes of the Prudential Capital Assessment and Review (PCAR) were being incorporated into banks’ recapitalization and restructuring plans helped provide credibility to the exercise; 3/ Included for completeness only—not intended as a crisis stress test; surveillance stress testing exercise was conducted in a crisis environment
Sources: Central Bank of Ireland (CBI); European Banking Association (EBA); Federal Reserve (Fed); IMF; Oliver Wyman; and Roland Berger; Note: Even though some variables were not provided as part of the general macro scenarios, they were used in the determination of key market risk drivers; 1/ Included for completeness only—not intended as a crisis stress test; surveillance stress testing exercise was conducted in a crisis environment; 2/ Information not disclosed
Summary
They are increasingly being used by country authorities as an instrument for regaining the public’s trust in the banking system during the current global financial crisis This new tool, known as a “crisis stress test,” is essentially a supervisory exercise accompanied by detailed public disclosure to remove widespread uncertainty about banks’ balance sheets and the authorities’ plans for those banks. The assessment by the Turkish authorities of its banking sector following the 2001 crisis is an example of a public diagnostic exercise which helped to restore confidence in the banking sector and its supervisor and regulator It did not include a forward-looking stress test component, its overall objective and design included the necessary attributes for a credible outcome.
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