# **1. Introduction**

Central Banks in Central and South Eastern Europe (CSEECBs) are mandated to foster financial stability in the financial systems of their respective countries. The Central Banks fulfill this mandate by conducting macroprudential policy including macroprudential oversight and implementation of macroprudential policy instruments. The main practical approaches of the macroprudential oversight are monitoring of financial stability indicators and conducting stress-testing exercises. Especially the latter should be forward looking and tailored to the specifics of a given financial system. Since the financial systems in Central and South Eastern Europe are often at rather early stages of development, compared to high-income countries, traditional banking business dominates the systems. As a result, the stress-testing exercises primarily involve banks and inform the macroprudential policy makers about the needed policy adjustments which are predominantly banking sector oriented. As in the case of monetary policy, it is important that the stress tests of banking systems are sufficiently forward-looking to take into account the transmission lags of macroprudential policy and the effectiveness of its instruments.

This paper aims to review the stress-testing practices of central banks in Central and South Eastern Europe<sup>1</sup> and outline the challenges in the area of stress testing for the respective institutions going forward.<sup>2</sup> As the first of its kind, this review paper should help CSEECBs benchmark themselves against their peers in the region and compare their ongoing development efforts in the area of stress testing. Furthermore, this paper should also help the IFIs identify the most needed areas for technical assistance and prioritize on their development assistance in the area of stress testing across the region. In this respect we focus on components of a macroprudential stress test which typically involve constructing the baseline and stress macroeconomic scenarios, mapping the macroeconomic scenarios and other microeconomic factors to risk factors, calculating risk exposures to different risk factors, and estimating outcome indicators to inform macroprudential policy makers. We find that the main challenges for the CSEECBs underscore the need to address problems with data reliability, consideration of quantitative microprudential indicators in macroprudential stress tests, explicit incorporation of dynamics in stress test to include reaction functions of banks and macroprudential policy, institutionalization of macroprudential policy responses to alarming stress-test results and use of the top-down and bottom-up stress test results in supervisory communication, and cooperation of macroprudential and microprudential

> 1 The countries considered include: Albania, Austria, Bosnia & Herzegovina, Bulgaria, Croatia, Czech Republic, Hungary, Greece, Kosovo, FYR Macedonia, Montenegro, Poland, Romania, Serbia, Slovak Republic, and Slovenia.

> 2 The review is based on information shared by the participants of the seminars on “Advances in Stress Testing in Central and South Eastern Europe”, held in Prague and Thessaloniki in November 2009 and May 2010 respectively. The presentations included: Colakovic (2010), Csajbok (2009, 2010), Dascalescu (2010), Gersl (2009), Guttierez (2010), Huljak (2010), Ivanovic (2010), Jurca and Klacso (2009), Klacso (2010), Manolov (2010), Melecky (2010), Puhr (2009), Seidner (2010), Sekulic (2010), and Woreta (2010). Addition information has been obtained from the financial stability reports of the respective central banks and individual follow-up surveys with the country representatives in the seminars.

2