IMPROVING SOLVENCY RISK MANAGEMENT
AIM 67. 5 : Describe several ways to improve the management of solvency risk at
In the wake of therecentfinancialcrisis,thecollapseof thebankingsectorinIcelandhas producedseveral lessons thatcan be usedtoimprove diemanagementofsolvencyrisk
atbanks.Thekeywaysforimproving themanagementofsolvencyriskarediscussedas follows.
The needforliquiditystress testing.Oneobvious andunambiguouslesson learnedfrom
theIcelandbankingcrisis isto notoverlyfocusonsolvencystresstesting, especiallyat the expenseofliquiditystress testing.Theglobalfinancial crisishasclearlyshown thata
liquiditycrisis can rapidly make asolvent bank insolvent. Solvent banksare notimmuneto liquidity shortages.However,apoorlycapitalizedbank may surviveforsometime ifit has
strongliquidity toserviceandrolloverdebt.Thus, toimprovethemanagementofsolvency
risk,banksshould givemoreattendon toliquiditystress tesdng while maintaining their routinesolvencystresstesdng.
Looking beyondstandardnumbers.LStress testsconducted priortothehankingcrisis attemptedtoidentifyriskfactorsby focusingon information inbalance sheets and profit andlossaccounts.Thestresstestsignoredinformation relatedtooff-balance sheet items aswellas thekeynotes(andexplanations) regardingthe consolidated financialstatements,
such asdetailsonassetmaturities, investments inspotandderivative contracts,and
currencypositions.However, this information Ls criticalto identifyingmajor risk sources.
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Movingbeyond normalscenarios.Stress testsdid not cakeintoconsiderationsevere, unusual,or undrinkablescenarios*But theglobalfinancialcrisisdid producea strong warning char, regardlessof theliquidity position ofabank,stress testsshould incorporate severe riskscenarios on a routine basis,such asabank run ondeposits, refusalof lenders to
rollovercredit,and breakdownof die settlementandpaymentsystem.
Insteadoffocusingon asingleextremescenario,thestress testfocusshouldbe toidentify
asetofscenarioswhichcanseverelybreak thepre-established normalitystandards. For example, capitalizationorliquidity mayfall wellbelowtheacceptablestandards,givinga big jolt tothesystem.Stress testsshouldtakeaholisticviewof risk instead offocusingon each riskindividually.
Focusingonkeyrisks.Stresstestsshouldfocusonkeyriskitems onboth theassetand liabilitysidesof the balance sheet.Difficultyindisposingshort-termassetsquickly to realize cash to meetcreditors’obligationscould triggerseverenegativeconsequences. For example,stress testsshould takeinto consideration theriskofsecurities tradingin theevent
of breakdown of die settlement andpaymentsystem,similar towhaL occurredduringthe
2008bankingcrisisinIceland.Ontheliabilityside,keyrisks mustbeincorporatedinstress
testing. Forexample, what ifthe traditionallystable and much reliedupon fundingsources, retailorwholesale,are not availableasunder normalconditions?
Simplebut focused testing. Stress testsshouldnotbecomplex.Simple testsfocusingonkey
risk areasandextremescenarios can produce valuableinsightstodevelopaneffectiveex-
anteriskmanagementplan.
Integration ofstresstestingandriskmanagementplanning. Anotherlesson learned from Iceland’sbankingcrisis is that theremust bea closeintegrationofstress testing resultsand development of contingencyrisk pluming.Stress testingis notaveryusefulexerciseifit is
not usedfordevelopinganex-antesound riskmanagement plan.
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KEY CONCEPTS
AIM67.1
Threelargecommercialbanks inIcelandwere highlyleveragedwitha total debtof
$61billion, nearly 12times diesizeof thegrassnational product.Also,the commercial bankingsectorwas nearly nine timesbigger than theGDPof Iceland when diis small Europeancountrywidiopen tradepolicieswashit bydiewavesof theglobalfinancial crisis.Multipleeventssummarize the Icelandic debtcrisis, includingarapid and substantial declinein die valueof diekrona, breakdownof the international payment system,
unavailabilityof short-term marketfunding,financingandservicingdebtobstacles, depositors7panic, chronicliquidityshortages,andeventually,government takeoverof operadons of die threelargest commercialhanks.
AIM67.2
The typicalscenariosatdie Icelandic banksin theperiodleadingup to the financialcrisis wereapparently based on die belief diatabank withadequate capitalization
solvent bank—doesnot attractliquidityissues, whereasabank withstrongliquidity may havesolvencyrisks. The FinancialSupervisoryAuthority(FME) anddie central bank primarilyfocusedonsolvencyrisk.Stress testresultsshowed diat the majorbanks in Icelandwerewell-capitalized,andtheycould withstand theadverse market conditions and unexpectedlosses.
strong,
AIM67.3
Threesetsof liquiditystress testswerehasedonthe shocksused by theFME, thecentral hank,and actualshocks that occurredduring thehankingcrisis.Assetsand/or liabilities
wereshockeddependingoil theweight (percentage)ofaspecificshocktospecificitem(s}.
The short-term assetsand/or liabilitieswereimpactedmore(less) if the weightof the shock waslarger(smaller).
AIM67.4
Stress testsundertaken bythe Financial SupervisoryAuthority(FME) and die central hank (Sedlahanki)were differentdue to the typesand theweightsof shocks. TheFMEstress test
did notgive shocks toliabilities.Itinjected overalllightershocks{weights} compared to die
stress testemployed bythecentral bank. Thefunding gapratio, followingactualshocks,
wasmuchlower compared tofundinggap ratiosproducedin thestress testsconducted by theFME,aswellasthe central bank. Thatis, the actualliquidity shortagewasmuchworse compared to theshortage estimated bybodi tests.Thus,stress testsconducted byboth theFME andthe central hankwereineffectivein correctly assessingdiemagnitudeof the liquidityshortage followingthecrisis.
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AJM67.5
Thereireseveral waystoimprove die managementofsolvencyriskat banks.Stresstests
need toassessliquidity risk becauseasolventbank canquicklybecome insolvent,as witnessed in the2008global bankingcrisis,if faced with aliquidity shortage*Stresstests
should focusonoff-balance sheetitemsaswell asthenotes to the consolidated financial
statements.Stress testsshouldincorporatesevereand unusualriskscenarios.Theyshould alsofocus onkeyrisk items on both theassetand liabilitysidesof the balance sheet,such as severeobstaclesinfundingavailabilityorassetliquidation.Stress testsshouldnot be complex,and there should beameaningfulintegration between thestresstestfindingsand riskmanagement plans.
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CONCEPT CHECKERS
Atthetimeofitscollapsein 2008,Iceland’s bankingsector:
A. wasabouttwice aslargeasitsGDPatdie endof2007*
B. hadlive major banks with substantial market share.
C. wasusingthe kronaasdie localcurrency;whichsignificandyappreciatedagainst othercurrencies.
D. experiencedashutdownof private interbankcreditfacilities.
Thestresstestsconducted bythe Financial Supervisory Authority (FME) and the central bankinIcelandintheperiod leading up to thebankingcrisis:
A. primarilyfocusedonliquidityrisk.
B. primarilyfocusedonsolvencyrisk.
C. showedasignificantliquidityrisk.
D* showedasignificantsolvencyrisk.
Thestresstestingof banksin the periodleading uptothehankingcrisis inIceland:
A. wasconducted by the Financial Supervisory Authority(FME)yearly.
B. wasnot transparent,astheresultswerenotmadepublic.
C. wasendorsedandapproved bythe International Monetary Fund(IMF).
D* focusedoilindividualbanksas diestressscenarios werenotappliedacross die bankingsector.
Thestresstestsconducted bytheFinancialSupervisory Authority (FME) and Sedlabanki (thecentral bank) toassess theliquidityposition ofanIcelandicbank gavethesamemagnitude(weights) of shocks towhichof thefollowing?
A. Loansand advancestodomesticborrowers*
B. Loansand advancestoforeignborrowers.
C. Changeinbondprices(investmentsinbonds).
D* Changeindomestic stock prices(investmentsindomesticequity).
Inordertoimprove diemanagementofsolvencyrisk, ahank should:
A. focuson solvencystress testing andnot theliquiditystresstesting.
B. focuson liquiditystress testingand notthesolvencystresstesdng.
C. focusmoreon balancesheet itemsandignoredie off-balance sheetitems.
D. focuson unusualor unexpected riskscenarios.
Foradditional Book 4, Topic67practice questionsset;
I.
2.
3.
4.
5.
Self-TestQuestions:#H(page255)
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CONCEPT CHECKER ANSWERS
1. D Atdietimeofitscollapse,Iceland’sbankingsectorwasnearlynine timeslargerthan itsGDP.
Therewereonlythree major banks, and the lerona fellinvaluesignificantly.
2. B Stresstestsprimarily focusedcmsolvencyrisk. Noneof therestsrevealed anystrongsolvency riskorliquidityconcern,
3. D TheFMEconductedstresstestingonaquarterlybasisinaverytransparentmanner.The
stresstestingwasnotapproved bytheIMF.Thestresstesdngfocusedonindividual banks and the(same)stressscenarioswerenotappliedacrossthebankingsector.
4. D The FMEstress testdidnotgiveashocktothe firsttwoitems,and theweightfor the bond shockwasdifferentin bothstresstests,
5. DA bankshould conduct bothsolvency and liquiditystresstests,hutthelessonlearnedfrom theglobalfinancialcrisisdemandsthatthey shouldpaymoreattentiontoliquiditystress testing.Ahankmustincorporate off-balance sheet risksintostresstesting, and should focus
on unusualorunexpectedriskscenarios.
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