Results of a macroeconomic stress test of the banking system, 2013–14
Excerpt from the "Israel's Banking System - Annual Survey for 2013" to be published soon: The Banking Supervision Department conducted a macroeconomic stress test based on a uniform scenario for the banking system in the past year.
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Excerpt from the "Israel's Banking System - Annual Survey for 2013" to be published soon:
- The Banking Supervision Department conducted a macroeconomic stress test based on a uniform scenario for the banking system in the past year. A system-wide stress test carried out by supervisory authorities is an accepted international standard, and contributes to understanding the risks facing the banking system in general and each bank on its own.
- The test was based on two scenarios, a base scenario and an adverse scenario. The adverse scenario presents a severe domestic recession with difficult ramifications for the housing and real estate industry, as a result of a deterioration in the geopolitical situation. This is a severe scenario, similar to scenarios published in other advanced economies.
- In a situation in which the stress scenario is realized, a significant impact is expected on the banking system, but no risk to its stability is seen. The banking system would show a cumulative loss of greater than NIS 3 billion, and a negative return on equity during the two years of the scenario. The core capital ratio of the banking system will decline to 7.5 percent at the end of the period, and the ratio for individual banks will range between 6.1 percent and 8.3 percent.
The Banking Supervision Department has been carrying out macroeconomic stress tests based on a uniform scenario on the banking system since 2012. The stress test assesses the effects of various scenarios on the bank’s business results. The banking corporations are required to estimate the results of the scenarios through various methodologies that they develop, while at the same time, the Banking Supervision Department conducts its own test on the same scenarios, applying a uniform methodology for all the banks. Having supervisory authorities conduct a uniform stress test is an accepted international standard. The test contributes to an understanding of risks facing the banking system in general and each bank on its own.
Beginning with the test carried out this year (which began in 2013), the Banking Supervision Department integrates the uniform stress test as part of the Supervisory Review and Evaluation processes (SREP), and its integration includes both quantitative and qualitative aspects. In parallel, the banking corporations are required to integrate it into their internal capital adequacy assessment processes (ICAAP). This is intended to utilize the process as an aid for evaluating the banking system’s resilience, to ensure the existence of sufficient capital levels, to test the banks’ capital planning, to set capital requirements and to take other measures as necessary—in accordance with best practices customary around the world. In addition, this process allows the banking Supervision Department to assess the banks’ ability to conduct a stress test based on statistical models and other methodologies, and supports the understanding of risk drivers in the banking corporations while strengthening the supervisory dialogue with them. The characteristics of the scenario and the results of the test conducted by the Banking Supervision Department are presented below.
B. The scenarios
The test was based on two scenarios—a base scenario and a stress scenario. The stress scenario is an adverse one and its parameters are calibrated to stress the main risk factors in the Israeli economy and in the banking system. The scenario horizon is 9 quarters, and the starting point is September 30, 2013.
- The base scenario: The values of the variables in this scenario are based on the Bank of Israel’s macroeconomic models, international institutions’ projections of global developments, and other assessments regarding economic developments—all as of the date on which the scenarios were formulated (September 2013). It is important to note that this scenario does not reflect the Bank of Israel’s official macroeconomic forecast, which is based on additional sources.
- The domestic stress scenario: A macroeconomic scenario of a severe domestic recession with serious ramifications for the housing and real estate industry, as a result of a deterioration in the geopolitical situation. The scenario is based on the recession of 2002, though somewhat more severe, and is characterized by a downturn in the real economy together with an increase in Israel’s risk premium. The downturn is reflected in a sharp decline in GDP and in private consumption, and a resulting serious negative impact on the labor market and the housing and real estate market. Asset prices on the capital market are also markedly affected. Figure 1 presents the development of the macroeconomic variables in each of the scenarios. An international comparison relating to the major variables of the scenario shows that the level of adversity of the stress scenario is similar to the level accepted in other advanced economies.
C. The findings
The results of the stress test indicate that a realization of the adverse scenario would have a significant impact on the banking system, but no risk to its stability is expected. The immediate impact derives from exposure to credit risk and to market risk. The recession will make it difficult for business and private borrowers to meet their commitments, and the banks will record large losses in the credit portfolio, half of which originate from the housing, construction and real estate credit portfolio. The concentration in the Israeli credit market is also expected to worsen these losses. Sharp increases in bond yields, and declines in the stock market, are expected to cause significant losses in the banks’ securities portfolio which, in turn, will negatively impact profitability and erode capital.
The negative impact to the profitability of the banking system could be significant and prolonged: A cumulative loss of more than NIS 3 billion and return on equity of -2.2 percent in 2014 and of -1.8 percent in 2015. The core capital ratio of the banking system will be impacted, and would decline from 9.3 percent in September 2013 (the beginning of the scenario) to 7.5 percent at the end of the period (end of 2015). The core capital ratio at the banks will range from 6.1 percent to 8.3 percent—levels that attest to the stability of the system and to it having sufficient capital buffers to absorb serious macroeconomic shocks to the Israeli economy (Figure 2 and Figure 3).
It should be noted that the uniform stress test does not include an analysis of the effects of the scenario on liquidity risk or on operational risk. It also does not include peripheral indirect ramifications such as the withdrawal of deposits by nonresidents, a decline in ratings for the banks and reduced investor confidence. The results of the test do not take into account actions that the banks may take with the aim of minimizing the damage of the scenario, such as selling stocks and bonds and reducing credit volumes.
Historical macroeconomic data and development of the scenarios, 2000-15
SOURCE: Historical data—Based on Central Bureau of Statistics and Tel Aviv Stock Exchange; Base scenario and stress scenario—Bank of Israel calculations.
 The five major banking groups (Leumi, Hapoalim, Discount, Mizrahi-Tefahot and First International) and the two independent banks (Union and Bank of Jerusalem).
 The Banking Supervision Department made a separate assessment of how various stress scenarios would affect liquidity risk in the banking system.