Top-down” stress test
Stress Testing is a tool to assess the financial sector resilience. The assumptions underlying the stress test are not and should not be interpreted as NBG’s forecasts. These assumptions represent only theoretical simulation and are used to assess resilience of the financial sector if the scenarios were to realize. Based on the definition and purpose of stress test, underlying assumptions should be reasonably severe, less likely, but plausible.
The National Bank of Georgia evaluates the ability of the commercial banks to withstand economic shocks under three different scenarios. The macroeconomic scenarios are one of the main building blocks and the starting point for the stress testing exercise. Stressed scenarios are designed using the Macroeconomic Stress Scenario Builder while the baseline scenario comes from the Georgian Economy Model (GEMO). The scenarios include the assumptions about the projected path of GDP growth, loan interest rates both in domestic and foreign currencies, Nominal Effective Exchange Rate (NEER) and the House Price Index. The scenarios are not forecasts, but are instead hypothetical scenarios and they were constructed to help illustrate how commercial banks could react to the adverse economic conditions associated with severe recessions.
The other parts of top-down stress test framework include the assessment of credit and market risks, projection of non-interest income and finally the potential impact on capital ratio, which is estimated by observing the evolution of profit and loss and balance sheet statements. It should be noted that the stress test is based on the assumption of a static balance sheet and does not assume any active response from banks to the shocks in the system nor any change to business models. The stress test has a three-year horizon and no maturity adjustments to assets and liabilities over this period are considered.
Credit risk is the most important factor affecting banks’ capital adequacy ratio in Georgia, which is caused by a borrower's failure to meet contractual obligations. Since banking sector is mainly focused on lending, while maintaining foreign currency position close to zero and holding securities until maturity, main risk stems from the credit quality. Negative macroeconomic developments, both internal and external, can cause credit losses. Therefore, modeling credit risk is the most important area of stress testing. Depending on the severity of the shock, commercial banks’ balance sheets and profit and loss accounts can change dramatically, which in turn affect banks’ capital ratios.
In order to evaluate credit losses in different scenarios, the NBG employs dynamic econometric credit risk models, in which the dependent variables are based on non-performing loan (NPL) ratios and the projection of these variables are intermediary indicators for the credit risk assessment. Considering high dollarization and the fact that the corporate and household sectors behave differently during the periods of economic shocks, the NBG estimates credit risk models separately for household and corporate sectors by their currency of denomination.
After the projection of non-performing loans, loan loss provisions are calculated in different scenarios. For this purpose, the provisioning rates are applied to the projected non-performing loans which differ by bank, borrower sector and loan currency. Provisioning rate are also affected by dynamics of macroeconomic variables. In addition, the provisions are adjusted by write-off rates, which are based on historical data and expert judgment.
Interest rate risk is a potential loss caused by a change in market interest rates. A sudden change in interest rates can significantly affect banks’ profit statement. To assess the impact of the interest rate risk on the capital adequacy ratio, the NBG uses the maturity-adjusted gap analysis. Throughout the stress horizon, the net interest income (NII) is affected by the interest rate shocks applied to interest rate sensitive assets and liabilities as the positions reach their time of repricing. In addition, interest rate margins are further compressed in stress scenarios based on historical distribution. A rise in interest rates reduces the net interest income for banks, which have more interest rate sensitive liabilities than assets in the short-term bucket.
The exchange rate depreciation is considered in the revaluation of net open position, which has a direct impact on net profit and consequently on the bank capital. In addition, exchange rate affects the projection of balance sheet items and importantly, due to the high dollarization, results in the growth of risk weighted assets. The latter in turn constitutes to the deterioration of capital adequacy.
To assess the solvency of banks, capital ratios are calculated by dividing forecasted capital by the projected amount of risk-weighted assets. The capital projection is calculated by adding the projected net income to current capital and subtracting the increase in stressed-induced provisioning. In addition, the change in assets due to credit losses and exchange rate fluctuations is considered when projecting risk-weighted assets. Moreover, considering the fact, that the portion of capital is denominated in foreign currency, regulatory capital is also adjusted by the exchange rate fluctuations in the stress scenarios.