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| 14.07.2010 |
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| Stress Tests |
| The following is an extract from the Annual Survey of Israel's Banking System, 2009, currently under preparation. |
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In recent years, stress testing has become an important tool for risk management. It is used by regulators to assess the stability of the system and to identify sources of risk, and by banks as part of their internal risk management process and for the purpose of evaluating their capital adequacy. The global crisis emphasized the importance of stress testing, and the need to improve the practices and procedures used prior to and during the beginning of the crisis. |
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In 2009, the Bank Supervision Department examined a range of stress scenarios, and estimated macroeconomic models for evaluating the stability of the banking system and of individual banks and the banks’ sensitivity to various risk factors. |
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The results obtained from all the models and scenarios estimated indicate that after taking into consideration the effects of the various shocks examined, the average capital adequacy ratio in the banking system remained higher than the minimum requirement. |
| In recent years, stress testing has become an important tool for risk management. It is used by regulators to assess the stability of the system and to identify sources of risk, and by banks as part of their internal risk management process and for the purpose of evaluating their capital adequacy. The stress tests can provide a bank’s management with warnings of unexpected serious results likely to arise due to the realization of various types of risk, and provide an indication of the capital required in order to absorb losses in the event of large shocks. They are a supplementary tool to models such as VaR (Value at Risk), and focus on exceptional events. Thus, for example, while VaR reflects the day-to-day behavior of the market, stress tests look at the performance of a portfolio over “irregular” periods, and therefore provide information on risks outside the range captured by the VaR model (Figure 1). |
| In December 2006 the Committee of European Banking Supervisors (CEBS) issued a guideline on the use of stress tests. Based on this regulation, and as part of the process of implementing the Basel II Accords in Israel, the Bank Supervision Department published in June 2008 “A Draft on the Subject of Principles for Implementation of Stress Testing in the Framework of the Second Pillar.” The draft was designed to promote inculcation of stress testing as an integral part of the risk management processes and the evaluation of the appropriateness of the level of capital adequacy in banking corporations. |
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| The global financial crisis that began in 2007 emphasized the importance of stress testing. Its depth and perseverance raised doubts among regulatory authorities as to the reliability of the stress tests used prior to the crisis, and their suitability in light of the rapid changes that were taking place, since the results of the crisis were more serious than those predicted by stress testing. In May 2009 the Basel Committee on Banking Supervision (BCBS) published “Principles for Sound Stress Testing Practices and Supervision,” following its investigation of the procedures used in carrying out stress tests prior to and during the crisis. Based on this investigation, and in an effort to improve the existing procedures, formal guidelines were developed for banks and regulators with regard to the goals and management of stress tests, as well as their implementation. In January 2010 the Bank Supervision Department published a Hebrew translation of this document, as part of its efforts to upgrade the system of corporate risk management, control, and corporate governance, and for the purpose of clarifying the Department’s expectations in this area (this document, translated into Hebrew and the above-mentioned June 2008 document appear on the Bank of Israel website). |
| In continuation of the inculcation of the Basel II guidelines, and as part of the lessons learned from the crisis, the Economics Unit of the Bank Supervision Department carried out a number of stress scenarios, reflecting a range of events. These examined the consequences for the banking system as a whole, and the adherence of the individual banks with the capital requirements established for 2009. Among other things, the scenarios examined included the collapse of a large group of borrowers, a deterioration in the quality of the bank credit portfolio, the effect on households' debt burden of a rise in the interest rate on unindexed variable-interest housing loans, interest rate shocks in various indexed sectors, and exchange rate shocks. |
| In addition, in 2009 the Bank Supervision Department estimated macroeconomic models for the credit risk in the business sector, the construction and real estate industry, and the household sector. These models relate a system of macroeconomic factors to the credit risk in the banking system, and are used for stress testing. It should be noted that these models use historical statistical relations to forecast the development of future risks; their ability to encompass especially extreme reactions is limited, particularly when they rely on data reflecting a long period of stability. |
| As stated above, the results obtained from all these models and scenarios indicate that after taking into consideration the effects of the various shocks examined, the average capital adequacy ratio in the banking system remained higher than the minimum requirement. |
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