Static Balance Sheet Assumption

From Open Risk Manual

Definition

Static Balance Sheet Assumption is an important methodological simplification[1] employed in the performance of Bank Stress Testing but also potentially any other Credit Risk analysis that concerns evolving (dynamic) portfolios of credits. The assumption requires that the impact of the stress test scenario is to be measured on the hypothesis of a constant balance sheet and of an unchanged or stable business model throughout the projection period

Specification

The assumption prohibits from taking into account, for the calculation of the impact of the scenarios, changes in the assets and liabilities of the institution that derive from:

  1. Management actions
  2. Increases or work-outs of existing lending
  3. Differences in maturities or other characteristics of assets or liabilities.


NB: Static does not imply unchanging, the application of the stress test methodology might change the size and the composition of the balance sheet, and particularly the capital base, over the projection period due to, for example, new defaults, impairments, increase of stock or value adjustments of financial assets.

The assumption permits the inclusion of new assets and liabilities as far as these new items bear the same main characteristics (maturities, risk profiles, etc.) with the current ones. Without the inclusion of new assets and liabilities the Balance Sheet is said to be in Run-Off Mode.

Example

For example[2], a 10-year bond with residual maturity of 5 years at the start of the exercise is supposed to keep the same residual maturity of 5 years throughout the exercise.

Application to Net Interest Income (NII)

  • Assets and liabilities (both in the banking and in the trading book) that are repriced (i.e. mature) within the time horizon of the exercise are replaced with similar financial instruments in terms of type, credit quality at the time of repricing and original time to reprice (both reference interest rate and margin) of the instrument.
  • With regard to the loans and receivables portfolio, the static balance sheet assumption applies to the portfolio as a whole – i.e. when considering both the performing and non-performing part. Indeed, it is expected that, under stress, the total volume of performing assets will decrease and simultaneously, non-performing assets will increase.
  • Banks should make a distinction between existing positions, maturing positions and new (i.e. repriced) positions in terms of both the average volumes of each of these three components and the Margin and Reference rate
  • Under the static balance sheet assumption, the sum of the existing, maturing and new positions’ average volumes (both in the banking and in the trading book) should remain constant over time
  • The banks’ interest income and expenses evolve over the stress test time horizon as a result of:
    • The repricing of maturing assets/liabilities,
    • The change in the margin and/or reference rate components earned/paid on assets/liabilities, and
    • The migration of performing positions to non-performing.

References

  1. EBA/CP/2016/28
  2. EBA: 2018 EU-Wide Stress Test - Draft Methodological Note