IMF Survey: IMF Developing New Tools to Find Financial Trouble Spots

January 15, 2008

  • IMF enhances quality of financial sector stress testing
  • Analyzes interaction between markets and macroeconomy
  • Developing range of analytical tools

The IMF is developing new applications for stress tests and other quantitative risk-assessment models to help identify financial system vulnerabilities in member countries, in the wake of the U.S. subprime crisis.

IMF Developing New Tools to Find Financial Trouble Spots

Swiss headquarters of Bank for International Settlements, one of several institutions that the IMF is working with (photo: Quilleret Jean/SIPA)

Financial Stability Modeling

It has enhanced and expanded its research agenda on quantitative financial stability modeling in an effort to meet with the new challenges arising from financial globalization, in which markets are linked in complex patterns.

The recent turmoil in credit markets is a clear reminder that financial globalization brings not only benefits—the deepening of financial markets and internationalization in capital allocation—but also new risks and challenges for policymakers. Globalization links national economies into a vast network of closely interconnected on- and off-balance-sheet positions, creating the potential for financial instability to be transmitted from one country to other countries or affect regional and global markets.

A range of analytical tools that are being developed by the IMF's Monetary and Capital Markets Department (MCM) as part of this extensive research agenda will be able to better account for the complex linkages between the global economy and modern financial markets. These tools will therefore help sharpen and strengthen IMF's monitoring of member countries' financial systems.

Multiple approaches

The primary objectives of this quantitative work are to

• enhance the quality of stress tests and other quantitative analyses performed in the context of the Financial Sector Assessment Program (FSAP),

• support technical cooperation on risk-based supervision and on the implementation of the Basel II capital framework, and

• facilitate "offsite" surveillance of national and global financial systems, and hence IMF surveillance more broadly.

The IMF is focusing on a range of analytical perspectives—each with different strengths and limitations—to analyze the interactions between the macroeconomy, financial institutions, and financial markets. Feedback on these analytical tools from inside and outside the IMF will continue to be important in pointing to the more promising approaches.

Complex models for complex realities

The specific areas on which the IMF is actively working include

    1. further developing credit risk analysis;

    2. focusing more on "second-round effects" of shocks—both interactions within the financial sector and feedback between the financial sector and the macroeconomy; and

    3. expanding existing approaches to liquidity risk modeling.

• Credit risk modeling. Work in this area revolves around three broader methodologies, each of which can be applied either at an aggregated level (a group of banks) or at the bank-by-bank level, and each of which has already been used for stress testing or scenario analysis in a number of countries.

For example, one application models portfolio credit risk based on CreditRisk+, a tool that is already being used by financial institutions and supervisors to compute the credit portfolio loss distribution—that is, the probability of losses on a given credit portfolio. This application can be useful for scenario stress testing when complemented with models of the probability of default (the likelihood that a credit will not be repaid) and loss given default (the fraction of the credit that will not be recovered in the event of default).

Other relatively new directions of work include macro stress testing under data constraints, an approach that allows the impact of macroeconomic shocks on banks' economic capital in the presence of short time series of default probabilities to be quantified. It simultaneously accounts for changes in the correlation among banks' assets through the economic cycle.

The contingent claims approach (CCA)—a method that combines balance sheet and market information with widely used finance techniques to construct risk-adjusted balance sheets that better reflect credit risk—is also being used to conduct scenario analysis, and it can be applied to a wide range of financial institutions that issue securities in sufficiently deep markets.

• Measurement of second-round effects. Stress tests need to look beyond "first-round" effects—the impact of macroeconomic shocks on financial institutions—and incorporate the second-round effects of shocks. One way of doing this is to develop a measure of financial fragility at the system's level—a banking stability index—based on banks' joint probability of default. This approach can also be applied at the global level by looking at joint probabilities of default (or other measures of stability) for key large complex financial institutions.

Another approach to modeling contagion uses the extreme value theory framework to capture the possibility that large, extreme shocks are transmitted across financial systems differently than small shocks. A third approach is to develop a CCA-based framework that provides risk indictors and can be linked to more macroeconomic models of varying degrees of complexity.

• Liquidity risk modeling. Work is under way to enhance the range of tools and methods available to stress test exposures to liquidity risk—a risk area that the current turmoil has made more apparent. The three main directions of work in this area are (1) building on existing methodologies to identify funding liquidity risk (including nontraditional sources, such as securitization) and expanding them to incorporate market (asset) liquidity risk (including the effects of asset fire sales and crowded trades); (2) capturing off-balance-sheet concentration risk—for example, excessive committed and uncommitted credit lines to a single counterparty; and (3) extending the CCA-based framework using information from equity option prices to capture the effects of increased uncertainty of asset values, market illiquidity, potential for fire sales, and funding liquidity risk.

Engaging our partners

The IMF is committed to continue exchanging knowledge and experience on financial stability modeling, including through organizing and attending workshops and seminars, such as the Expert Forum on Advanced Stress Testing Techniques. This IMF-organized event, which takes place every 18 months, is attended by supervisory agencies and the central banks that are leading the work in this area.

The IMF's staff also participates in a number of external working groups and platforms on stress testing and associated risk modeling, including at the Basel Committee for Banking Supervision, the Deutsche Bundesbank, and the London School of Economics. A number of joint projects with central banks, supervisory agencies, and private sector partners are also ongoing or under discussion to develop and apply some of the methodologies described above.

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