EDITORIAL: State Bank of Pakistan (SBP) has evolved as a pro-active and forward-looking regulator in the last two decades. The financial stability of banks has been managed well by SBP after their privatization. This task became more critical after the breakout of COVID-19 as the central bank rightly allowed principal deferment of loans to give businesses the breathing space in unprecedented times. But at the same time, this is increasing the stress on banks' balance sheets. For that, regular rigorous stress testing is imperative.
SBP is now gathering weekly liquidity data to enhance its coverage; whereas the bulk of credit data is now being collected and evaluated on monthly basis (previously, it was on quarterly basis). All these measures are to keep the central bank ahead of the curve on any systemic risk developing within the banking sector or constituent thereof.
Apart from the pandemic-related additional measures, the SBP has revised its existing guidelines on stress testing. This is to align with changing local dynamics and to come closer to global best practices. Earlier, stress testing was confined to conventional banks and DFIs. Now Islamic banks, Islamic branches within banks and microfinance banks have also been included.
Islamic banks in Pakistan follow Islamic Financial Service Board (IFSB) based in Malaysia. The balance sheet reporting of Islamic banks is different from their conventional counterparts, and the framework under which Islamic banks are operating is not the same. SBP was working on the Islamic banking stress testing guidelines for long (much before this deadly pandemic surfaced) and they are now being implemented. In case of microfinance banks, they did not have sophistication in data gathering to include them for stress testing. Now these banks are crossing the bridge. SBP has also enhanced the credit limits of individuals and micro enterprises, and it is now increasingly becoming important for microfinance banks to follow stress testing protocols.
Stress testing is not something new in SBP. The first guidelines were issued in 2005. After the 2008 financial crisis, risk management and stress testing were revamped across the globe. SBP kept on evolving as well and has made good strides. There are numerous additions in stress testing framework and methodology. The changes are not confined to the addition of Islamic and microfinance banks. There are changes in macro stress testing. The objective is to see the impact of macro variables on banks' financial health. For example, would recovery from COVID-19 be V-shaped, U-shaped, or L-shaped and what would be needed to be done in each scenario. For adverse scenarios, L-shape recovery is considered. This would have an impact on real economy and in turn on the balance sheets and profitability of banks.
SBP is now making this scenario testing mandatory for domestic systemically important banks (D-SIBS), and other banks are encouraged to do the same. D-SIBS include NBP, HBL and UBL. Previously, scenario stress testing was optional; now it has been made mandatory for D-SIBS, and other banks have been encouraged to do it too. These banks are selected on the bases of their sizes, interconnectivity prowess and a few other factors. Scenario testing is a sophisticated tool. On the other hand, sensitivity is relatively simple where one variable is changed and its impact is evaluated. In case of scenario analysis, inter-linkages of variables are incorporated in stress modeling. It is closer to real life cases. The adverse scenarios are developed, based on historic and hypothetical adversities. There is broadening of sensitivity shocks as well.
Then there are new guidelines in operational risk testing. It was covered earlier as well, but now the spectrum has been expanded. The operations are to be tested against various shocks such as cyber security and money laundering. In the last FSR testing, large- and medium-sized banks were found to be resilient in adverse conditions. Even in worst cases, for most of the banks, Capital Adequacy Ratio (CAR) was above the minimum statutory levels. Some small banks could be in hot waters in case of adverse shocks. SBP appears to be fully cognizant of the fact and is actively working with these banks to ensure that no crisis emerges.
Copyright Business Recorder, 2020
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