Stress tests for all times

  • Business
  • Wednesday, 20 May 2009

IT seems strange that central bankers are still talking about conducting stress tests in the aftermath of the financial turmoil. Some even think that it is abating and, therefore, irrelevant to be digging up scenarios for testing.

Nobody likes to be reminded of bad times and the mention of stress tests jolts memories of those terrible days when age-old banks in the United States and Europe were going down like nine pins, crushed by severe losses and a massive credit crunch.

Stress testing should not be done only when there is a crisis, more so liquidity stress testing in a situation of continued risk aversion.

This is demonstrated in financial bulletin reports which said credit in the US dollar market was still tight. A few weeks ago, Khazanah Malaysia Bhd and Sime Darby Bhd raised three-year money at 1.5% above the London Interbank Offered Rate (Libor).

For the US$500mil raised by Khazanah, only three banks – Bank of Tokyo-Mitsubishi UFJ, Mizuho Bank and DBS Bank – took part. In the case of Sime which raised US$280mil, the same three banks including OCBC Bank participated.

“Premium companies are getting such high rates,” observes a banking analyst. In normal circumstances, more banks would be willing to lend for such large amounts.

In view of the mixed signals to recovery, stress testing would be a pre-emptive measure as the failure of financial institutions to meet expected and unexpected cashflow needs could trigger another round of fallout.

Following the announcement of US bank stress test results, European banks also were reported to be conducting similar exercises.

Under liquidity stress testing, the focus is on the banking institution’s ability to manage its liquidity mismatches and maintain adequate liquidity buffers.

A survey conducted by Bank Negara early this year on stress testing practices of several banking institutions indicated that the methodologies of stress testing for liquidity risk were generally at a less developed stage than for credit or market risk.

Thus, the current challenge is to develop stress scenarios that are inter-related and also to assess the impact of any external changes.

The question raised is since we have ample liquidity, why do we need to do liquidity stress testing? True, but liquidity has to be managed in such a way that it is useful to the financial system.

The banking system forms the backbone of funding for the economy and hence, banks must lend to generate growth. In view of the cautious credit situation, it is imperative for banks to continue lending and at the same time, manage their liquidity risk.

Some interpret the latest decision to conduct stress tests as a signal that the economy could be going for another dip and a rise in non-performing loans which generally lag the system by six months or more.

On a positive note, the effects of the stimulus packages will also have a lag period of six to nine months, and that, to a certain extent, can help offset the other negative factors.

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