An address by Francois Groepe,
Deputy Governor of the South African Reserve Bank,
at the Actuarial Society Banking Seminar
The Maslow Hotel, Sandton
2 August 2017
Bank-wide stress testing as a risk management tool
Members of the Actuarial Society, ladies and gentlemen.
Thank you for the invitation to address you at this third Actuarial Society Banking
Seminar. The South African Reserve Bank (SARB) would like to congratulate the
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Actuarial Society of South Africa on its efforts to build expertise in banking and on
becoming a world leader in this regard. Your initiative to introduce a Banking
Fellowship coupled with allowing actuaries to qualify as banking actuaries is
commendable and could make important contributions to improving the resilience and
stability of the domestic banking sector.
My address today will focus on stress testing and how it is being applied as a risk
management tool. I would also like to share the progress the SARB has made and the
methodologies it has applied in its approach to stress testing the South African banking
sector.
Stress testing forms part of the macroprudential monitoring framework applied by the
SARB in fulfilling its now-expanded mandate of protecting and enhancing financial
stability, in addition to its price stability mandate. As you are all aware, the mandate of
the SARB, specifically its primary objective and independence, as entrenched in the
Constitution, has come into sharp focus recently. The primary objective of the SARB
is stated in the Constitution: "Protect the value of the currency in the interest of
balanced and sustainable economic growth." This objective and the independence
provided to the SARB in the Constitution can only be changed by a two-thirds majority
of the members of Parliament; thereafter any such change would need to be ratified
by the Constitutional Court. In this way, the courts protect the SARB against any
unlawful encroachment of its independence.
Furthermore, the notion of a central bank as a public institution, with the goal of
promoting monetary and financial stability in the interest of the general public, is
remote from the traditional concept of a commercial company with a profit motive.
Central banks have been structured by their respective governments to suit public-
interest ends. The shareholding structures have been retained in some cases,
including by the SARB and in various others, such as the central banks of Belgium
and Switzerland. But the inconsistencies with the shareholding of private companies
necessitated a realignment of the rights and powers of shareholders in central banks.
Limitations were consequently built into the rights and powers of the shareholders in
the SARB, such as no policymaking or management roles, a fixed return of R200 000
per annum on shares held, no claim on the reserves held by the SARB, and the
election of a minority of the Board of Directors (Board). The management of the
business of the SARB, including the setting of monetary and financial stability policies,
vests in the Governor and Deputy Governors, appointed by the President after
consultations with the Minister of Finance and the Board of the SARB.
The Financial Sector Regulation Bill, approved by Parliament in June 2017 and
currently awaiting sign-off by the President, makes provision for an expanded mandate
for the SARB, which includes financial stability. Financial stability aims to enhance
resilience to systemic shocks and to mitigate the macroeconomic costs of a disruption
in financial sectors. Financial stability is not an end in itself but is generally regarded
as an important precondition for sustainable economic growth, serving the
constitutional mandate of the SARB. Financial stability is not about preventing shocks
or crises, but more about identifying and mitigating the build-up of risks and
vulnerabilities in the financial sector. Neither is financial stability about preventing bank
failures at all cost, as the failure of non-systemic banks ameliorates the risk of moral
hazard and reinforces market discipline.
A stable banking sector is, however, crucial for financial stability as these risks and
vulnerabilities often originate from systemically important banks and their clients in the
corporate and household sectors. To identify the vulnerabilities that might be building
up in the banking sector early enough and to ensure proactive mitigating action, stress
testing has become an important tool in the toolkit of systemic regulators. It adds an
important macroprudential dimension to the supervision of banks by assisting
supervisors and macroprudential authorities in evaluating the aggregate capital
position of the largest banking firms as well as their individual capital levels.
Internationally active banks have been applying stress testing at the level of individual
institutions since the early 1990s; today bank regulators require the use of stress tests
for monitoring both market and credit risks. Macro stress testing, as a tool to assess
the vulnerability of entire financial systems, is instead much more recent. It has been
an important component of the Financial Sector Assessment Programs (FSAPs)
launched by the International Monetary Fund (IMF) and the World Bank in the late
1990s, and has become an integral part of the financial stability toolbox of
policymakers. It was during one of these FSAPs that stress testing experienced severe
criticism and major challenges as a technique to assess the soundness of banking
systems. In its Financial System Stability Assessment after the FSAP on Iceland in
financial indicators of the Icelandic banking
August 2008, the IMF stated that the
system were above the minimum regulatory requirements and indicated that stress
tests had suggested that the system was resilient. As you all know, the Icelandic
banking system collapsed soon afterwards.
To the uninitiated, what the IMF said then may sound astonishing. But it simply echoed
the message of the stress tests carried out by authorities and banks around the globe
ahead of what turned out to be one of the worst financial crises in world history, namely
that the financial system was resilient, sound, and strong. This was the unyielding
message confronting those who were deeply involved in assessing vulnerabilities
during the years of the so-called Great Moderation, even as the cracks started to
appear.
It is, of course, all too easy to criticise stress tests after the fact, but the most recent
global financial crisis raised a key question: what can and cannot be expected of stress
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tests, both now and in the future? It was only in 2009 when bank regulatory agencies
in the United States (US) applied their Supervisory Capital Assessment Program, or
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SCAP, popularly known as the 'bank stress tests' that the technique regained some
of its credibility. The SCAP marked the first time that the US bank regulatory agencies
had conducted a supervisory stress test simultaneously across the largest banking
firms.
In retrospect, the SCAP stands out for me as one of the critical turning points in the
global financial crisis. It provided anxious investors with credible information about
public disclosure of the
prospective losses at banks. Supervisors' stress-test results
helped to restore confidence in the banking system and enabled its successful
recapitalization. The resilience of the US banking system has greatly improved since
then, and the more intensive use and greater sophistication of supervisory stress
testing, as well as supervisors' increased emphasis on the effectiveness of banks' own
capital planning processes, deserve some credit for that improvement.
Today, the US has two distinct but related supervisory programs that rely on stress
testing. The first is the stress testing required by the Dodd-Frank Act, which has the
purpose to quantitatively assess how bank capital levels would fare in stressful
economic and financial scenarios. The second program, called the Comprehensive
Capital Analysis and Review, combines the quantitative results from the stress tests
with the more qualitative assessments of the capital planning processes used by
banks in the US.
These supervisory programs, developed as part of regulatory reforms following the
global financial crisis, have been strongly challenged by the new political regime in the
US. The US Federal Reserve (Fed) conducted its first exercise in 2009 to increase
confidence in the system. Today, bankers believe the tests have morphed into a
mysterious, laborious, and time-consuming process from what was once a
straightforward examination of financial strength. The outcome determines how much
capital banks must hold, but experience shows that getting a passing grade can be
tough. The tests also prove to be resource-intensive as some of the bigger banks have
to call on hundreds of their employees to work on stress-test submissions each year.
and bankers argue that reducing the stress tests' complexity and frequency
Politicians
could not only save man-hours, but also help the US economy by stimulating more
lending. They argue for a fresh look at how stress testing is conducted, making their
case in meetings with legislators who are stewarding a financial overhaul by the
current US administration. Regulators, however, remain sceptic, pushing back on the
industry's pleas, arguing that it is crucial that a strong capital regime be maintained,
especially as it applies to systemically important banks. Former Fed Governor Daniel
Tarullo said in April: "Neither regulators nor legislators should agree to changes that
would effectively weaken the regulatory regime."
Irrespective of what the outcome of the debate in the US might be, macro stress testing
has become a tool of the macroprudential frameworks that authorities are
stress testing
implementing globally. It is, however, important to keep in mind that
cannot address all the risk management weaknesses by itself. As part of a
comprehensive approach, it has a leading role to play in strengthening bank corporate
governance as well as the resilience of individual banks and the financial system.
Whether macro stress tests will ever be able to act as effective early warning devices
is an open question, given the analytical challenges.
By contrast, macro stress testing can be quite effective as a tool for crisis management
and resolution, since in that context its messages may be more reliable. More
generally speaking, macro stress tests can discipline thinking about financial stability
risks. In the process, they can yield additional benefits, such as:

helping to reconcile the widely different perspectives of the various stakeholders
(banks, supervisory authorities, central banks, and the public at large);

fostering better communication;
 the performance of individual firms' risk
cross-checking models; and

identifying important data gaps.
That said, in order to yield the hoped-for benefits, it is critical to design stress tests
properly, tailoring them to the specific purpose. Furthermore, the tool can only be the
beginning, never the end, of a conversation about financial stability risks. It can only
Stress testing
be a complement, never a substitute, for other tools and processes.
plays a particularly important role in:
 providing forward-looking assessments of risk;
 overcoming the limitations of models and historical data;
 supporting internal and external communication;
 feeding into capital and liquidity planning procedures;
 informing the setting of banks' risk tolerance levels; and
 facilitating the development of risk mitigation and/or contingency plans across a
range of stressed conditions.
Ideally, one would like to subject the whole financial system to a macro stress test. In
practice, however, tests have considered parts of the overall system. The banking
sector is the most common object of analysis, given its importance for financial
stability. But stress tests have sometimes also covered other institutions, such as
insurance companies and pension funds. These tests have tended to assess the
strength of institutions in individual jurisdictions, although typically including their
consolidated balance sheets worldwide. The only coordinated multi-country tests have
been the recent exercises in the European Union. More recently, the European
Banking Authority started the process of its 2018 stress testing of Europe's largest
banks when it published its draft stress-test methodology. This test will again look at
the effect of macroeconomic stress on a bank's viability, taking into account market
risk and litigation risk. It will, however, be much tougher than previous tests, as it will
include the International Financial Reporting Standard (IFRS) 9, which requires that
banks model credit risk losses for loans even before they have defaulted. This is likely
to result in higher levels of provisioning and may potentially impact somewhat on
capital adequacy ratios.
Incremental risk provisioning under IFRS 9 will focus on loans
that show deterioration in borrowers' credit quality since
the inception of the loan. It is
therefore expected that banks that are challenged by low growth and persistent asset
quality pressures will be more severely affected.
In the United Kingdom (UK), the Bank of England (BoE) announced the key elements
of its 2017 stress test in March. The 2017 stress test includes two stress scenarios.
Alongside the annual cyclical scenario, the BoE is for the first time running an
additional exploratory scenario. The aim of this additional scenario is to consider how
the UK banking system might evolve if recent headwinds to bank profitability persist
or intensify. It includes weak global growth, persistently low interest rates, and
stagnant world trade; it has a seven-year horizon to capture these long-term trends.
As I have mentioned before, stress testing forms an important component of the
financial stability framework in South Africa.
As part of the 2014 FSAP for South Africa,
the IMF conducted a full stress-testing exercise for the banking and insurance sectors.
The focus of the exercise was on both solvency and liquidity stress testing. In its
recommendations, the IMF proposed that the SARB develop a macroprudential stress-
testing framework (following a top-down approach) to complement the existing bottom-
up exercises conducted by banks.
In January 2015, the SARB established a Stress Testing Division within its Financial
Stability Department. The division conducted a full stress-testing exercise on the
domestic operations of the major banks in South Africa during the period from
December 2015 to April 2016. Six major banks participated in the exercise, covering
in excess of 80% of the banking sector's assets. The SARB requested the participating
banks to conduct a bottom-up stress test focusing mainly on credit risk while the SARB
conducted a top-down exercise using a common scenario.
The Stress Testing Division followed a formal risk identification and scenario design
by developing a Risk Assessment Matrix, involving the identification of the most
relevant risks from the global and domestic environments, an assessment of their
likelihood, as well as a qualitative evaluation of their impact on the real economy, the
banking sector, and the financial system. Major global risks were identified on which
to base the scenarios; these included a surge in global financial market volatility
combined with a prolonged period of slower growth in both advanced and emerging
markets.
The results of the bottom-up stress tests were aggregated and validated against
SARB's
top-down stress-testing exercise. The participating banks were found to be
adequately capitalised to withstand significant credit losses throughout the stress
action by banks' management.
scenarios before taking into account any mitigating
This resilience stems from the high capital buffers already prevailing in the banking
system. The results of the exercise were published in the Financial Stability Review in
May 2016.
This stress-testing exercise was subjected to two peer reviews, firstly by the Deutsche
Bundesbank and secondly by the IMF, to ensure the robustness of the procedures
and future stress-testing exercises. The contributions that emanated from the peer
reviews have been actioned and incorporated into the refinement and expansion of
the SARB's governance
the stress-testing model and framework. In line with
framework, full stress-testing exercises will be conducted once every two years or if
and when they may be required. Work on the next cycle of the exercise is underway.
I would like to conclude by stating that banking systems are much stronger since the
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implementation of stress-testing frameworks and this has contributed in part to the
improvement of economies in many countries. Stress tests are forward-looking and
focus on improbable but plausible risks, as opposed to common risks. As a result, they
complement conventional capital and leverage ratios. The disclosure of the results of
coupled with firms' disclosure of their own
stress-testing exercises, stress-test results,
provides market participants with deeper insight and confidence, not only into the
financial strength of banks, but also into the quality of their risk management and
Stress testing is also proving highly complementary to supervisors'
capital planning.
monitoring and analysis of potential systemic risks.
A very important benefit of regular stress testing is that it forces banks and supervisors
to develop the capacity to assess the enterprise-wide exposures of their institutions to
risks, and to use this information to ensure that they maintain adequate levels of capital
and liquidity. The development and ongoing refinement of risk management capacity
is in itself critical for protecting individual banks and the banking system, upon which
the health of our economy rests.
I wish you everything of the best with your further deliberations today.
Thank you.
Reference
Borio, C., Drehmann, M. and Tsatsoronis, K. 2012. Stress-testing macro stress testing:
does it live up to expectations? Basel: Bank for International Settlements.