Bank stress tests suggest improvement

The latest stress tests of commercial banks carried out by the Nepal Rastra Bank (NRB) have shown some improvement compared to previous year’s results, especially due to the improvement in liquidity and capital adequacy indicators.

This is what the International Monetary Fund’s (IMF) recent report based on the assessment of its article IV mission suggests. The IMF report says fewer banks are vulnerable to liquidity and credit shocks in 2012 compared to 2011.

Stress testing is a risk management tool used to evaluate the potential impact on a firm of a specific event and movement components like earning, liquidity and capital.

Citing the recent stress tests of commercial banks by the central bank, the IMF report said a standard credit shock would push the capital adequacy ratio of 20 among 32 commercial banks below the regulatory minimum. The number of such banks in 2011 was 22.

Standard credit shock has been defined as 15 percent performing loans deteriorating to substandard, 15 percent substandard loans deteriorating to doubtful, 25 percent doubtful loans deteriorating to loss and 5 percent of performing loans deteriorating to loss.

Likewise, the number of banks that may turn illiquid after five days of standard withdrawal shock is 14 in 2012 compared to 19 in 2011, according to the report. Standard withdrawal shock is the withdrawal of customer deposits by 2 percent and 5 percent in the first two days and 10 percent each in the following three consecutive days.

According to the report, commercial banks are more resilient to deposit withdrawal shocks, and to withdrawals by large individual and institutional depositors. It is mainly due to the improvement in liquidity on the back of strong remittance inflows, states the report.

Bankers say the report reflects the reality. NIC Bank CEO Sashin Joshi said the report shows the improvement is consistent with the measures taken by the central bank and the commercial banks to address credit and liquidity shocks. “Banks have increased their liquidity and capital adequacy ratio. I don’t think the banks will face major shock due to deterioration of asset quality and there will be a liquidity crisis like two years ago,” said Joshi.

According to Joshi, the central bank directive on managing an additional one percent capital in the capital adequacy ratio as buffer capital would also help absorb credit shocks. Currently, banks are required to maintain CAR at 10 percent and the central bank has directed them to keep an additional one percent as caution measure.

There is also a slight improvement in the response to credit shocks, particularly those calibrated to real estate loans, according to the report. In case of 25 percent of performing loans of real estate and housing sector is directly downgraded to loss loans, CAR of 11 commercial banks will come below the required 10 percent level.

The number of such banks in 2011 test was 15. The improvement is due to the decrease in banks’ loans to the realty sector over the last three years.

Commercial banks’ direct exposure to construction and real estate sectors has declined from 19.5 percent in 2009-2010 to around 16.5 percent in 2011-12. Indirect exposure through collaterals has also declined from 66 percent to 56 percent over the period. “The overall exposure is still high,” states the report.

Joshi, however, said with banks increasing provisioning of real estate loans, systemic risk is unlikely to happen even if the realty loans are defaulted.

The central bank also says the chances of BFIs’ exposure to realty sector affecting the system immediately are slim. “The lending to the realty sector has so far been managed well,” said NRB Deputy Governor Maha Prasad Adhikari. “A little more time is required for BFIs to be able to recover realty loans.”

He said the liquidity surplus is also unlikely to remain at last fiscal year’s level due to increased lending against deposits. “However, liquidity crisis like before looks unlikely.”