## Integrating stress tests within the Basel III capital framework: a macroprudentially coherent approach

## Source details

**Canonical URL:** [Integrating stress tests within the Basel III capital framework: a macroprudentially coherent approach](https://www.imf.org/-/media/files/news/seminars/mcm-lse-bologna_session5.pdf)

## Other formats

- [Markdown version](/-/media/files/news/seminars/mcm-lse-bologna_session5.pdf.md)
- [Structured JSON version](/-/media/files/news/seminars/mcm-lse-bologna_session5.pdf.json)

---

### Introduction and context
- Post-crisis financial sector reforms introduced macroprudential tools aimed at enhancing the stability of the system and reducing the volatility of the cycle.
- Banks' capital adequacy is established by the Basel III capital standards and by supervisory stress tests (STs).
- Basel III requires banks to build-up buffers during expansions, and allows for their use during downturns.
- Loss absorbing buffers: Capital Conservation Buffer (CCoB) & Countercyclical Capital Buffer (CCyB).
- Supervisory STs assess in a forward-looking manner the resilience of both banks and the system as a whole to adverse macroeconomic shocks.

### How to integrate stress tests (STs) within Basel III
- Proposal: introduce a Stress Test Buffer (STB), additional to those in Basel III Pillar 1.
- Role of STs: assess whether Basel III buffers are sufficient to withstand a macro shock, and translate ST outcomes into a capital requirement consistent with Basel terminology.
- Formula (as presented):
  - STB = max [ ST Losses / Risk weighted assets − (CCoB + CCyB), 0 ]
- Implementation: introduce the STB as a capital requirement additional to other Basel III Pillar 1 requirements (minimum and buffers).
- The STB transforms ST results into the Basel "language" of buffers.

### STB implications and systemic considerations
- The STB provides an explicit capital add-on linked to stress losses, increasing the transparency of how STs affect capital requirements.
- STB can be particularly relevant for G-SIIs (G-SIIB in slides), increasing resilience for systemic banks through higher capital requirements when stress losses exceed existing buffers.
- Consideration of voluntary buffers and interaction with capital shortfalls under stress testing.

### Macroprudential coherence: aligning ST severity with Basel III cyclical logic
- Basel III minimum capital requirements and buffers imply higher build-up during expansions and permitted lower resilience in downturns.
- Macroprudential coherence requires ST severity to follow the same cyclical path: ST severity should be procyclical—increase during expansions and decrease in downturns.
- Ensuring that STs do not counteract the intended cyclical operation of Basel III buffers is central to a coherent capital framework.

### Implementing STs with cyclical severity: method and challenges
- Implementation strategy must enhance predictability of severity and forestall inaction bias.
- Need to define a simple and robust severity measure.
  - Recession-based measures are preferable to probabilistic ones.
- Recommend a "constrained discretion" approach to severity choice, based on a simple severity measure and rule.
- Need to define rules guiding severity for crucial parameters of the adverse scenario (e.g., unemployment rate, house prices, stock market indices).
- Severity choices of domestic components of scenarios should take into account heterogeneity in domestic financial and business cycles.
- The definition and implementation of such a framework in the euro area is maybe more challenging than in other jurisdictions but equally necessary.

### Conclusions and policy recommendations
- Policy makers should ensure coherent, transparent and predictable use of new regulatory instruments.
- Key implications for a bank capital framework based on Basel III & STs:
  - Macroprudential coherence requires procyclical ST severity.
  - Transparency is enhanced with the introduction of a stress test buffer (STB).
  - Predictability benefits from a constrained discretion approach based on a simple severity measure and rule.
- Practical steps:
  - Adopt STB as an additional Pillar 1 requirement when stress losses exceed existing buffers.
  - Design severity rules tied to observable recession indicators and key scenario parameters.
  - Account for cross-jurisdiction heterogeneity when setting domestic scenario severities.

---


_Source: https://www.imf.org/-/media/files/news/seminars/mcm-lse-bologna_session5.pdf_