Macroeconomic Stress Testing: Preliminary Evidence for Austria

Financial stability is gaining importance among monetary and financial authorities as the process of globalization continues. In the last few decades, there has been a decrease in the impediments to trade and capital flows and an increase in information flows, financial innovation, deregulation and advances in technology, which has all contributed to the formation of closer links among global financial markets. While this has aided the efficiency and overall functioning of the global economy, there is a downside risk arising from this interdependence of markets. Namely, financial crises have a greater potential to spread beyond national borders and have a magnified impact on the global economy. With increased risks of contagion, central banks must be more vigilant to potential vulnerabilities that may threaten financial stability on a national and global level. Episodes such as the near failure of Long-Term Capital Management (LTCM), the Asian crisis, the Scandinavian banking crisis and Argentina s recent debt default highlight the urgency for action on the part of policymakers to maintain and ensure financial stability. The Asian crisis showed how trade and financial linkages can propagate a financial disturbance internationally. A currency crisis which started in Thailand spread rapidly to other emerging Asian economies including Indonesia, Malaysia and South Korea. The crises in the Asian countries exposed the weakness of their banking systems and prompted the International Monetary Fund (IMF) to step in with various bailout packages to prevent a total economic collapse in these countries. The Scandinavian banking crisis in the first half of the 1990s coincided with the bursting of the property price bubble. Property prices had escalated to exuberant levels; as real estate was used as collateral to finance ever-increasing loans, the sharp fall in property prices led to significant losses for banks that had large exposures to the sector. The Scandinavian banking crisis is estimated to have cost 5% to 7% of GDP. Central banks have a vital role in ensuring financial stability and minimizing fragility in the financial system. In a number of countries, central banks take part in supervisory activities. More generally, a key responsibility of monetary authorities is the lender-of-last-resort role. In this context, the question arises as to how vulnerabilities in the financial systems can be detected. Observing potential signs of heightened risks present in the financial system is important for central banks as they rely on such insights to be able to take both preventive measures and adequate action in crisis management. A key method supporting policymakers in the task of conserving financial stability is macro stress testing, because it performs quantitative analyses of financial fragility. The purpose of this paper is to perform macro stress tests for the Austrian banking system. Our focus is on the impact of credit risk. This risk category has recently been the topic of considerable analysis for a number of reasons. First, credit risk is still the preeminent risk category for banks in the euro area. Second, the changing regulatory framework and the development of new products have generally strengthened the focus on modeling default risky assets. In particular, the ongoing Basel II process and the rapid development of credit derivatives have motivated researchers to undertake quantitative work on credit risk. By means of a scenario analysis, we estimate the impact of an increase in risk Harvir Kalirai, Martin Scheicher