Stress testing a portfolio of assets (such as loans) involves evaluating what would happen to the portfolio in the face of various adverse events. Applied across a bank, a stress test can be described as "the evaluation of a bank's financial position under a severe but plausible [economic] scenario." (2) Stress testing is an important risk management tool for banks in evaluating their vulnerability to various types of risk across their balance sheet. The Basel II international capital framework has a specific role for stress testing to help ensure banks have sufficient capital to absorb unanticipated losses in severe economic downturns. (3)
As a central bank with a financial stability function, the Reserve Bank is also interested in stress testing at an aggregate level. Stress testing is particularly useful for assessing financial stability by highlighting the vulnerability of the financial system to certain risks. Stress testing can assist the supervision of individual banks, and help in the formulation of prudential policy.
A stress test may examine the consequences for banks of a full macroeconomic scenario that affects multiple aspects of the banks' business, or concentrate on a downturn in a particular sector. Stress tests can also be classified by the source of the models used for the test. Bottom-up stress testing sees participating institutions use their own models to determine the effects of scenarios determined by the regulator. The regulator then collates results to provide insights into the system-wide impact. This is the type of stress test the Reserve Bank undertook in 2003 (see RBNZ 2004) and again in 2009 in collaboration with the Australian Prudential Regulation Authority (APRA) and the Reserve Bank of Australia (RBA). (4)
A top-down stress test involves the regulator collecting data on the whole financial system or a particular part of it and applying a modelling framework themselves. The Reserve Bank has previously done work of this sort to analyse the residential mortgage lending of the banks (see Harrison and Matthew 2008). In this article, we describe a model the Reserve Bank has recently constructed to analyse risk in the dairy farming sector.
The dairy stress testing model presented in this article is a model of credit risk--the risk that a bank will take losses because borrowers do not repay their loans. A credit risk stress testing model involves imposing changes to key macroeconomic variables that affect performance in the sector of interest, relating these changes to borrower default behaviour, and estimating the losses to the lending banks from these defaults and foreclosures.
The purpose of the dairy stress testing model is twofold. First, it may enhance banks' individual stress testing programmes by providing a base model for assessing credit risks in the dairy sector that the banks may wish to customise for internal use. Second, the model provides valuable insights into the vulnerabilities within the dairy sector and potential impacts of stress in this sector on New Zealand banks collectively.
International experts have noted that stress testing prior to the financial crisis often did not identify many of the important risks that had built up prior to the crisis and caused problems during it (see BCBS 2009). For example Geradi et al (2008) note that many analysts looking at the US housing market around 2005 felt nationwide house prices were extremely unlikely to fall substantially, partly as this had not happened in most of the historical datasets used by analysts. As residential loan defaults had also not occurred in great quantity in recent history, a historical analysis such as a regression would have had trouble identifying the risks of substantial loan defaults occurring in the future. Additionally, when large defaults did begin, the regression relationship would be likely to suddenly revise up …