West African Economic and Monetary Union: Financial Sector Assessment Program-Technical Note-Stress Tests, Credit Concentration, and Interest Rate Risks

IMFCountryReportNo.22/279 August2022 WESTAFRICANECONOMICANDMONETARYUNION FINANCIALSECTORASSESSMENTPROGRAM TECHNICALNOTEONSTRESSTESTS,CREDITCONCENTRATION,ANDINTERESTRATERISKS ThistechnicalnoteonBankStressTestforClimateChangeRiskswaspreparedbyastaffteamoftheInternationalMonetaryFundandWorldBankinthecontextofajointIMF-WorldBankFinancialSectorAssessmentProgram(FSAP).ItisbasedontheinformationavailableatthetimeitwascompletedinJuly2022. Copiesofthisreportareavailabletothepublicfrom InternationalMonetaryFundPublicationServicesPOBox92780Washington,D.C.20090Telephone:(202)623-7430Fax:(202)623-7201 E-mail:publications@imf.orgWeb:http://www.imf.orgPrice:$18.00perprintedcopy InternationalMonetaryFundWashington,D.C. ©2022InternationalMonetaryFund July22,2022 WESTAFRICANECONOMICANDMONETARYUNION FINANCIALSECTORASSESSMENTPROGRAM TECHNICALNOTE STRESSTESTS:CREDIT,CONCENTRATION,ANDINTERESTRATERISKS ThistechnicalnotewaspreparedbyIMFstaffinthecontextofaFinancialSectorAssessmentProgram(FSAP)missiontotheWestAfricanEconomicandMonetaryUnion.ThenotecontainstechnicalanalysisanddetailedinformationunderpinningtheFSAPassessment'sfindingsandrecommendations.FurtherinformationontheFSAPcanbefoundathttp://www.imf.org/external/np/fsap/fssa.aspx. Preparedby MonetaryandCapitalMarketsDepartment CONTENTS Glossary4EXECUTIVESUMMARY5INTRODUCTION7MACROFINANCIALSCENARIOS8AGGREGATIONTHROUGHSTATISTICALCLUSTERING13CREDITRISK14INTERESTRATERISK17CONCENTRATIONRISK18MEASURESANDRECOMMENDATIONS19CONCLUSION20 REFERENCES20 FIGURES 1.Scenarios—GrowthatRisk23 2.Scenarios—InflationatRisk24 3.BankClustering25 4.CreditRisk26 5.InterestRateRisk27 6.ConcentrationRisk28 TABLES 1.TableofRecommendations6 2.CompositionofSyntheticVariables—GaRModel9 3.CompositionofSyntheticVariables—IaRModel10 4.FinancialSoundnessIndicators29 ANNEXES I.At-riskModelsonSmallandNoisySamples32 II.EstimatingSyntheticVariablesbyPartialLeastSquares36 III.RiskAssessmentMatrix39 2INTERNATIONALMONETARYFUND IV.GroupingBanksbyStatisticalClustering40 V.Stress-TestingviaQuantileRegressions42 VI.RecursiveDynamicProjectionModel44 VII.MatrixofBankingSectorStressTests45 INTERNATIONALMONETARYFUND3 Glossary BCEAOCentralBankofWestAfricanStates(InFrench:BanqueCentraledesÉtatsdel’Afriquedel’Ouest) CBU FSAP BankingCommissionoftheWestAfricanMonetaryUnion(InFrench:CommissionBancairedel’UMOA) FinancialStabilityAssessmentProgram GaRGrowthatRisk GDPGrossDomesticProduct IaRInflationatRisk OLSOrdinaryLeastSquares PCAPrincipalComponentAnalysis PDsProbabilitiesofDefault PLSPartialLeastSquares RAMRiskAssessmentMatrix RWARisk-weightedAssets WAEMUWestAfricanEconomicandMonetaryUnion(Benin,BurkinaFaso,Côted'Ivoire,Guinea-Bissau,Mali,Niger,Senegal,andTogo) 4INTERNATIONALMONETARYFUND EXECUTIVESUMMARY Thistechnicalnotepresentsthestresstestsoncredit,interestrate,andconcentrationriskconductedbytheWAEMUFSAP.1Stresstestsoncontagionandliquidityrisksareaddressedseparately.2Stresstestsareanimportanttoolfordetectingfinancialsectorvulnerabilities,settinguptargetedbankingsectormonitoring,imposingpreventivemeasures,andinformingpublicdecision-makersofmacrofinancialrisksandcosts. Thesolvencyandinterestratestresstestsanalyzetheimpactofmacroeconomiccrisisscenariosonbankcapitalizationsviaanimpairmentoftheircreditportfoliosandprofitability.Thesestresstestsarebasedonanewmethodologythatcapturesthemacroeconomic,financial,andidiosyncraticsourcesofrisk.Theapproachincludesfoursteps:(i)constructionofbaseandadversemacroeconomicscenarios;(ii)clusteringofbanksinhomogenousgroupsusingstatisticalmethods; (iii)estimationofthesensitivitiesoftheprobabilitiesofdefaultandreturnonassetstoeconomicconditions;and(iv)projecteddeteriorationofbankportfoliosandprofitabilityunderthebaselineandadversescenarios. Thestresstestscenariosconsiderabaselineandanadversepost-COVID“recovery-at-risk”paths.ThebaselinescenariorepresentsaV-shapedrecovery,withastrongandrapidresurgenceofgrowth,whiletheadversescenariodepictsaU-shapedrecovery,withapersistentweakeningofgrowthbeforeitconvergeswiththebaselinescenarioattheendofthetestperiod.Thecumulativedifferencebetweenthegrossdomesticproduct(GDP)levelsintheadversescenarioandthebasescenarioisontheorderof15percentagepoints,or2.2historicalstandarddeviationsonaverage. Thiscouldbedescribedasa“severebutplausible”scenario.3 Theconcentrationtestsassesstheeffectofadefaultbythemainprivatedebtorsonbankportfolios.TheFSAPteamtestedbankconcentrationrisksbyconductingareversestresstestthatevaluatedthebreakingpoint,i.e.,themaximumnumberofcumulativelargeexposuresthatabankcancoverwithitscapital. ThestresstestresultsindicatethattheWAEMUbankingsystem’srecapitalizationneedsaremoderate,butsmallerbanksandbanksincertainmembercountriesarevulnerable.BankrecapitalizationcostsduetoshockstoeconomicgrowthandinflationarelimitedasapercentageofregionalGDP—tobetweenoneandtwopercent,dependingonthetypeofrisk(credit,interestrate,orconcentration),thescenario,andthedegreeofrisk.TherelativelysmallsizeofthebankingsectorasapercentageofregionalGDPandthesoundnessoflargebanksexplainsthe