research projects meant to improve the stress testing along this line are under way at many authorities. Among the central banks that included a loss distribution into their stress testing is the Austrian Central Bank.<sup>25</sup> In the Austrian stress test, an overall systemwide credit loss distribution is estimated by using a portfolio model, the Credit Risk Plus, which combines model-estimated sectoral default rates with individual borrowers’ default probabilities from the central credit register.<sup>26</sup> An alternative approach to estimating the expected loss is the estimation of the LLPs; an increase in LLPs accordingly diminishes net earnings. The Croatian Central Bank assumes that the LLPs will have the same growth as NPLs, which are model-estimated. LLPs are also estimated by the Romanian Central Bank (bank-level LLPs) and the Polish Central Bank (aggregate level LLPs).<sup>27</sup>

# **6.2. Capital Adequacy Ratio (CAR)**

Owing to the focus of the Basel Accords on capital adequacy, financial stability authorities express the outputs of their stress tests in terms of the number of banks with CAR under 8% (undercapitalized banks)<sup>28</sup> and accordingly the system-wide need for recapitalization. The capital adequacy ratio has in the numerator the expected loss subtracted from the buffer of capital and eventually profit, and in the denominator the risk-weighted assets (RWA). All CSEECBs express the output of the stress testing in terms of CAR and the need of recapitalization. After the estimation of the Expected Loss or LLP, some central banks use a combination of satellite models and expert judgments to estimate (net) earnings, and risk-weighted assets (RWA) – the remaining variables needed for CAR computation.

The Hungarian Central Bank estimates the expected earnings using a model for the net interest income. Total earnings are assumed to change in the same way as the net interest income (NII), because the total earnings themselves are seen as containing “too much noise” for modeling. The model used by the Hungarian Central Bank to forecast NII relates the NII to the loan stock, the industrial production, the CPI, the exchange rate, the short term interest rate and the steepness of the yield curve in a VAR framework. The Czech Central Bank’ 2010 FSR introduces a new income model, which estimates the adjusted operating profit (AOP).<sup>29</sup> This model relates the growth in the AOP to the change in the slope of the yield curve, growth in the volume of NPLs, average nominal GDP growth for the last six quarters and the lagged CAR. The Slovak Central Bank computes total NII as the sum of the NII from the portfolio of loans and deposits and the NII from the portfolio of securities. The expected NII from loans and deposits is based on

> losses are associated with a non-zero probability. The frequency of larger losses increases during an economic downturn, which increases the tail of the loss distribution.

> 25 Sveriges Riksbank also considers a credit loss distribution (Foglia, 2009).

> 26 See Foglia (2009), for a description of other approaches and research projects meant to incorporate a loss distribution instead of a point estimate of the loss.

> 27 See section 4.1.

> 28 The general 8% minimum CAR could substituted by a respective country-specific minimum CAR, and CSEECBs often use 10% or 12% as the minimum CAR.

> 29 The AOP is constructed as the sum of NII, profit from fees and commissions, and dividends received less administrative and other operating expenses.

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