Rules of Thumb for Bank Solvency Stress Testing. By Daniel C. Hardy and Christian Schmieder
IMF Working Paper No. 13/232
November 11, 2013
http://www.imf.org/external/pubs/cat/longres.aspx?sk=41047.0

Summary: Rules of thumb can be useful in undertaking quick, robust, and readily interpretable bank stress tests. Such rules of thumb are proposed for the behavior of banks’ capital ratios and key drivers thereof—primarily credit losses, income, credit growth, and risk weights—in advanced and emerging economies, under more or less severe stress conditions. The proposed rules imply disproportionate responses to large shocks, and can be used to quantify the cyclical behaviour of capital ratios under various regulatory approaches.


Motivated by the usefulness of rules of thumb,

this paper concentrates on the formulation of rules of thumb for key factors affecting bank solvency, namely credit losses, pre-impairment income and credit growth during crises, and illustrates their use in the simulation of the evolution of capital ratios under stress.4 We thereby seek to provide answers to the following common questions in stress testing:

 How much do credit losses usually increase in case of a moderate, medium and severe macroeconomic downturn and/or financial stress event, e.g., if cumulative real GDP growth turns out to be, say, 4 or 8 percentage points below potential (or average or previous years') growth?

 How typically do other major factors that affect capital ratios, such as profitability, credit growth, and risk-weighted assets (RWA), react under these circumstances?

 Taking these considerations together, how does moderate, medium, or severe macro-financial stress translate into (a decrease in) bank capital, and thus, how much capital do banks need to cope with different levels of stress?