SIMULATING FINANCIAL INSTABILITY nstability I INANCIAL F imulating S CONFERENCE ON STRESS TESTING AND FINANCIAL CRISIS simulatiON EXERCISES K AN B AL R NT CE AN Frankfurt am Main ROPE EU 12-13 July 2007 SIMULATING FINANCIAL INSTABILITY CONFERENCE ON STRESS TESTING AND FINANCIAL CRISIS simulatiON EXERCISES Frankfurt am Main 12-13 July 2007 © European Central Bank, 2008 Address Kaiserstrasse 29 D-60311 Frankfurt am Main Germany Postel address Postfach 16 03 19 D-60066 Frankfurt am Main Germany Telephone +49 69 1344 0 Internet http://www.ecb.int Fax +49 69 1344 6000 All rights reserved. Reproduction for educational and non-commercial purposes is permitted provided that the source is acknowledged. ISBN 978-92-899-0288-5 (print) ISBN 978-92-899-0289-2 (online) CONTENTS FOREWORD 7 Lucas Papademos SIMULATING FINANCIAL INSTABILITY 8 Olli Castren, Giacomo Caviglia, and Pedro Gustavo Teixeira PROCEEDINGS OF THE CONFERENCE WELCOMING REMARKS 16 Jean-Claude Trichet MACRO-PRUDENTIAL STRESS TESTING: REFLECTIONS ON CURRENT PRACTICES AND FUTURE CHALLENGES 19 Keynote address by Jaime Caruana SIMULATING AND DEALING WITH FINANCIAL INSTABILITY: CHALLENGES FOR CENTRAL BANKS 24 Keynote address by Lucas Papademos INTERVENTIONS AT THE POLICY PANEL 35 Malcolm Knight, Lars Nyberg, Peter Praet and Kenzo Yamamoto SESSION I MACRO STRESS TESTING – MOST RECENT EXPERIENCES THE IMF’S EXPERIENCE WITH MACRO STRESS TESTING 58 Mark Swinburne DEVELOPING A FRAMEWORK FOR STRESS TESTING OF FINANCIAL STABILITY RISKS 70 Nigel Jenkinson STRESS TESTING: THE SPANISH EXPERIENCE 79 Jesús Saurina MACRO STRESS TESTING – MOST RECENT EXPERIENCES 88 Comments by Gerhard P. Hofmann SESSION II MACRO STRESS TESTING – METHODOLOGICAL CHALLENGES A TRAVERSE FROM THE MICRO TO THE MACRO 94 Charles Goodhart 3 MODELING INSTABILITY OF BANKING SYSTEMS AND THE PROBLEM OF MACRO STRESS TESTING 102 Martin Summer MACRO STRESS TESTING: METHODOLOGICAL CHALLENGES 119 Comments by Sylvie Mathérat SESSION III TESTING FINANCIAL STABILITY ARRANGEMENTS – RECENT EXPERIENCES IN THE CONDUCT OF DOMESTIC CRISIS SIMULATION EXERCISES CONTINGENCY PLANNING AND SIMULATION EXERCISES: PRACTICAL APPLICATIONS 126 Michael Krimminger HUNGARIAN FINANCIAL CRISIS SIMULATION EXERCISES – CENTRAL BANKING PERSPECTIVE 135 Tamás Kálmán RECENT EXPERIENCES IN THE CONDUCT OF DOMESTIC CRISIS SIMULATION EXERCISES 144 Comments by Mauro Grande SESSION IV CROSS BORDER FINANCIAL CRISIS SIMULATION EXERCISES CHALLENGES FOR STRESS TESTING FINANCIAL SYSTEMS 150 Andreas Ittner TESTING THE INTERACTION BETWEEN AUTHORITIES OF COUNTRIES WITH SIGNIFICANT BANKING INTERLINKAGES 154 Thorvald Grung Moe INTERACTION BETWEEN THE AUSTRALIAN AND NEW ZEALAND AUTHORITIES 164 Chris Ryan CHALLENGES IN ARRANGING EU-WIDE CRISIS SIMULATION EXERCISES 171 Göran Lind CROSS BORDER FINANCIAL CRISIS SIMULATION EXERCISES 175 Comments by Svein Andresen 4 SESSION V SPECIFIC CHALLENGES FOR THE EU AND THE EURO AREA CHALLENGES FOR EU-WIDE MACRO STRESS TESTING 182 John Fell and Trevor Fitzpatrick GETTING END-GAME EXPECTATIONS RIGHT 194 Peter Nyberg EU FINANCIAL CRISIS MANAGEMENT ARRANGEMENTS FROM A CENTRAL BANKING PERSPECTIVE AND THE EUROSYSTEM FINANCIAL CRISIS SIMULATION EXERCISE 198 Panagiotis Strouzas SPECIFIC CHALLENGES FOR THE EU AND THE EURO AREA 207 Comments by John Berrigan ANNEXES CONTRIBUTORS 212 LIST OF PARTICIPANTS 219 5 FOREWORD This volume contains the proceedings of the conference on “Simulating Financial Instability”, held at the European Central Bank (ECB) on 12 and 13 July 2007, which gathered leading international academics and policy-makers with expertise in the areas of macro stress testing and financial crisis simulation exercises. This event, organised by the Directorate Financial Stability and Supervision of the ECB, proved to be a timely initiative since the financial market turmoil that erupted last summer provided a salutary reminder of the importance of the preparedness of pertinent authorities to address situations of financial stress. In this context, the conference provided a unique opportunity to exchange views and experiences in testing both the resilience of the financial system and the institutional arrangements for maintaining financial stability. Conference participants also identified and discussed the main challenges faced in the efforts to enhance the relevant testing methodologies. The conference provided a useful opportunity to become acquainted with the diversity and richness of the work being undertaken in this field. The results of this work are reflected in this volume. I am confident that it will provide an important contribution to the debate on the further enhancement of the institutional and analytical frameworks for safeguarding financial stability. Lucas Papademos, Vice-President of the European Central Bank Frankfurt, June 2008 7 SIMULATING FINANCIAL INSTABILITY OLLI CASTREN, GIACOMO CAVIGLIA AND PEDRO GUSTAVO TEIXEIRA1 INTRODUCTION Testing the resilience of the financial system to a situation of stress as well as the effectiveness and robustness of the financial stability arrangements should be a priority task for the authorities responsible for safeguarding financial stability. This is also so, because developments in financial integration and financial innovation potentially make the management of a financial crisis more complex, as the recent financial market turmoil has shown. Against this background, authorities are conscious of the need to devise methodologies enhancing their understanding of the development of risks in the financial system and of their potential impact on financial stability, as well as their preparedness to manage a financial crisis, both domestically and on a cross-border basis. In that respect, the conference organised by the ECB on “Simulating financial instability” in July 2007 provided a forum to share experiences from central banks, supervisory institutions and international institutions regarding the use of two elements of the toolkit for financial stability, namely macro stress testing of the financial system and the organisation of financial crisis simulation exercises. Macro stress testing represents a tool for assessing the vulnerability of a financial system to potential macroeconomic shocks. In particular, it involves the quantitative definition of a hypothetical shock, such as for instance a sharp fall in asset prices, in order to assess its likely impact on financial institutions’ balance sheets. This makes it possible to gauge the relative importance of risks to the stability of the financial system. The use of this tool has been fostered in particular by the IMF and the World Bank as one of the components of the Financial Sector Assessment Programs (FSAP) which are used worldwide. In the EU and the euro area, this tool is widely used by central banks for the performance of their respective financial stability tasks within their domestic financial sectors. The Eurosystem is currently working towards a framework that explores the frontiers of the cross-border dimension of macro stresstesting. Financial crisis simulation exercises, on the other hand, involve the real-life replication of the unfolding of a financial crisis in order to test – and help enhance – the institutional framework for managing crises, which encompasses the procedures for detecting disturbances to the financial system, assessing their nature and deploying the appropriate policy tools. Simulation exercises may test the procedures within a single authority, between authorities within a country, or the cross-border interaction between authorities. The Eurosystem has, thus far, organised two simulation exercises – in 2005 and 2006 – which tested its 1 Conference organisers, Directorate Financial Stability and Supervision, European Central Bank. 8 preparedness and ability to effectively address a financial crisis with the potential for systemic implications across several countries in the euro area. The focus of the ECB conference on these two subjects was innovative in demonstrating the potential interlinkages and synergies between macro stress testing and financial crisis simulation exercises which, thus far, have often been treated separately. Furthermore, the conference contributed to highlighting many of the challenges faced by macro stress testing and simulation exercises. These include issues such as coping with the pace of financial innovation, the availability of micro/supervisory data, accounting for contagion in cross-border stress testing and simulation exercises, and the specific European and euro area context. Finally, this conference provided the opportunity to reach a common understanding on the joint use of macro stress testing and simulation exercises as financial stability tools. This may support further cooperation among authorities with a view to enhancing the effectiveness of these two instruments. MAIN CONCLUSIONS - KEYNOTE SPEECHES AND POLICY PANEL The main conclusions from the conference may be drawn from the two keynote speeches delivered on that occasion and the concluding policy panel. In his speech on current practices and future challenges for stress testing, Jaime Caruana considered that a sensible approach to integrate finance into macro surveillance should contain at least three elements: continuous analysis of high- frequency data; assessment of the efficiency and robustness of the financial sector; and the use of stress tests to provide a more comprehensive picture of the interaction between underlying variables and shocks. The main challenges in the stress testing work include,