Conservative Constraints in Stress Testing

From Open Risk Manual

Definition

Conservative Constraints in Stress Testing are the set of choices and assumptions (parameter or model assumptions that aim to constrain (bias) the outcomes of a stress testing program in order to err on the side of conservatism.

A key motivation for the introduction of such constraints is to avoid gaming the methodology

EBA 2018 EU-Wide Stress Test

The following is a list of conservative constraints applicable to the EBA 2018 EU-Wide Stress Test[1]

Credit Risk

  • No cures from S3 assets are permitted (hence it is assumed that no cures from S3, charge-offs or write-offs should take place within the 3-year horizon of the exercise), i.e. the only acceptable transitions are from stages 1 to 2, 2 to 1, 1 to 3 or 2 to 3. No restatement of starting S3 exposures must be carried out. For the avoidance of doubt, all non-performing exposures as per EBA ITS 2, defaulted exposures as per Article 178 of the CRR, or impaired exposures as per the applicable accounting standard shall be classified as S3 under IFRS 9 for the stress test period.
  • The previous point is not to be confused with the inclusion of assumptions on future cure rates and write-offs in the generation of LGD parameters, which are implicitly assumed, where applicable. NB. An unbiased estimate will normally include a non-zero Cure Rate.
  • No negative impairments for any given exposure are permitted for any year or scenario, except and exclusively in the case of transitions from S2 to S1.
  • The Coverage Ratio for S1 assets (i.e. ratio of provisions to exposure) cannot decrease over the time horizon of the exercise (paragraph 111). Hence S1 assets cannot be assumed to benefit from credit quality improvements
  • The end-2017 level of REA serves as a floor for the total REA for non-defaulted and defaulted exposures in the baseline and the adverse scenarios. This floor must be applied separately to overall aggregate IRB and STA portfolios.
  • For securitisation exposures, the end-2017 level of REA serves as a floor for the total risk exposures separately for aggregate IRB and STA portfolios.
  • For the purpose of the stress test projections banks shall also assume without prejudice to other triggers that Stage 1 exposures which experience a threefold increase of lifetime PD (as defined under IFRS 9) compared with the corresponding value at initial recognition undergo an SICR and hence become Stage 2

Net Interest Income

  • NII cannot increase under the baseline or the adverse scenario
  • Under the adverse scenario, assumptions cannot lead (at group level) to an increase in the bank’s NII compared with the 2017 value before considering the impact of the increase of provisions for non-performing exposures on interest income
  • Under the adverse scenario, banks are required to project income on non-performing exposures net of provisions, subject to a cap on the applicable effective interest rate (EIR)
  • Under the baseline scenario, banks are required at a minimum to reflect a proportion of the changes in the sovereign bond spread of the country of exposure in the margin component of the EIR of their repriced liabilities
  • Under the adverse scenario, the margin paid on liabilities cannot increase less than the highest amount between a proportion of the increase in the sovereign spread and that of an idiosyncratic component
  • The increase of the margin component of the EIR on repriced assets is capped by a proportion of the increase in sovereign spreads
  • Although no methodological constraints are imposed on the reference rate of new originated or repriced instruments, it is expected that the change in the reference rate of these instruments is consistent with the macro-financial scenarios for risk-free yield curves

References

  1. EBA: 2018 EU-Wide Stress Test - Methodological Note

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