Analysis of default based on macroeconomic factors

The financial crisis and its effect on the real economy opened up a debate that has been going on since the beginning of 2009 on the changes that need to be made to regulations in the financial industry in order to prevent new crises, mitigate systemic risk and develop a balanced competition framework.

This process is resulting in different consultative documents and proposals for regulatory changes by the Basel Committee, FSB, FSF, IASC, CEBS and other international organizations and forums which, once calibrated on the basis of impact analysis exercises (QIS), will gradually enter into force until full implementation in 2012.

Specifically, the Basel Committee is preparing different proposals in relation to the three pillars of Basel II. Within the framework of Pillar 2, these proposals emphasize the importance of the capital measurement and planning process in the assessment of capital adequacy, as a fundamental part of the risk management control function in a financial institution.

This process requires financial institutions to engage in a capital self-assessment exercise whereby, based on the organization’s risk profile and on the current economic and financial environment, all material risks affecting the institution are identified and assessed in an integrated manner in order to reach a conclusion on its capital adequacy status. This process also involves conducting a number of rigorous stress testing exercises prospectively with a view to detecting possible developments or changes in market conditions that could negatively affect the organization.

Prior to the financial crisis, the scenarios used by banks in their capital planning processes tended to be continuous in nature, therefore stress tests did not always reflect a potential economic downturn and its impact on the solvency of financial institutions. This practice under a stressful economic situation has led to a greater than expected impact on the quality of assets and, therefore, on capital requirements, which has affected the level of solvency of institutions.

Financial institutions that are more advanced in risk management terms have developed internal risk measurement and management models and conducted planning exercises over the longer term, using three-year projections of their core capital base and capital consumption levels. This has made it possible to produce more accurate estimates of future solvency and to define contingency plans.
In that context, the study provides an analysis of credit risk capital requirements under different risk parameter scenarios and assumptions in order to assess how these scenarios affect the regulatory capital model and the economic capital charge.

Risk parameters comprise the various quantitative aspects to which capital is sensitive, such as through-the-cycle adjusted PD, pro-cyclicality, stochastic LGD, rating migration or concentration.

Such simulation exercise supplements the stress tests commonly conducted by financial institutions as part of their capital measurement and planning process, whereby, given a number of macroeconomic scenarios, specific risk parameters are set for each scenario and capital requirements are estimated.
Regulatory capital requirements were estimated for the purpose of the analysis, as was the figure that would result from using an economic capital model based on methodology commonly applied by IRB entities. Such estimates were made on the basis of standard portfolios from the Mortgage Loan (Retail) and SME segments of up to a EUR 100 million turnover, since these portfolios are more representative of Spanish financial institutions in terms of exposure.

The document is structured into the following sections:

  • Executive summary of the findings from the study.
  • Description of the portfolio characteristics used in the analysis.
  • Methodological basis
  • Tests conducted and analysis of results

For more information, click here to access the full document in pdf (only available in spanish).