Academic journal article Asian Social Science

Stress Testing of Commercial Banks' Exposure to Credit Risk: A Study Based on Write-Off Nonperforming Loans

Academic journal article Asian Social Science

Stress Testing of Commercial Banks' Exposure to Credit Risk: A Study Based on Write-Off Nonperforming Loans

Article excerpt


This study introduced a stress-testing model with a dummy variable that refers to write-offnon-performing loans (NPL) by Agricultural Bank of China. A new variable Y that indicated the rate of NPL in major national commercial banks in terms of logit transformation was applied to test stress tolerance. This article built a regression model on the basis of four explanation variables: the growth rate of GDP, indicator of customer price, the growth rate of supplying nominal currency and indicator of house price. Then we took advantages of VAR model to establish the relationship between variables. Based on the model, diverse scenario was set up to conduct stress test to NPL of commercial banks. The test covered four quarters and discovered that lower growth rate of GDP, slump in CPI, slowdown in supply of nominal currency and surging price of house are in charge of short-term increase in non-performing loans. From long-term perspective, the commercial banks would initiate internal system to mitigate the shock from volatile macro factors.

Keywords: credit risk, write-offnonperforming loans (NPL), VAR model, stress-test

(ProQuest: ... denotes formulae omitted.)

1. Introduction

Further opening of domestic financial market enables closer connection to international markets and challenges credit risk management of national commercial banks. Stress test is well known to evaluate the stability of commercial banks' credit system by stimulating potential risk exposure to extreme shock like financial crisis. The test works especially towards unexpected macro fluctuation on banking system and therefore plays a crucial role in forecasting and reducing systematic financial risk, which contributes to the stabilization financial system.

This paper applied macro stress test to the analysis of changes in NPL (nonperforming loan) of a commercial bank under given macro-economic shock. This article consists of three parts: Section one where we reviewed the national and international literatures concerning macro stress test. Section two where we stimulated a macro stress testing model in terms of NPL in Chinese commercial banks and quarterly macroeconomic data. Finally, we hypothesized certain scenario on the basis of model and then forecasted the new financial status of NPL of commercial bank in one year after extreme shocks.

2. Literature Review

IMF defined macro stress testing as a range of techniques used to assess the vulnerability of a financial system to 'exceptional but plausible' macroeconomic shocks. International Organization of Securities Commissions (1995) suggested that stress test analyzes the impact on portfolio of worst situation in market (rise of interest rate and crash of stock market). In 1999, IOSCO specified that stress test estimates and measures extreme but plausible risk of portfolio. Guidelines for the Stress Testing of Commercial Banks by CBRC (China Banking Regulatory Commission) indicates that The term "stress testing" as mentioned in these Guidelines refers to such a kind of risk analysis method in which the quantitative analysis method is usually adopted, the frangibility of a single bank, a bank group and the banking system is evaluated and judged through forecasting possible losses from small probability events or any other extremely unfavorable circumstances as assumed and analyzing the negative impact of such losses on the bank's profitability and capital, and necessary measures are thus taken.

Stress test can take advantage of different data sets at either portfolio or aggregate level. Aggregate-level stress test directly specifies the relationship between macro variables and banking aggregate elements and analyzes the risk exposure of a group of reporting firms under certain stress scenario. Portfolio-level stress test emphasizes on the banks' unique credit risk exposure to macro shock and discusses loss in each unit under exceptional circumstances. Portfolio-level stress test is more operational and includes feedback effect in financial institutions. …

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