STRENGTHS AND VULNERABILITIES: INSTITUTIONS AND MARKETS
A set of stress tests was carried out by the NBS, based on scenarios proposed by
the FSAP team, with the aim of analyzing the extent of the risks identified above. Appendix II provides a description of the tests that were undertaken, the methodology used,
and the results.
The broad finding of the stress tests is that the Slovak banking system could
withstand substantial market or credit shocks without facing difficulties. The banking
system would be able to withstand a significant decline in real estate prices, and direct effects of exchange rate and interest rate volatility. The most significant effect on banks would result
from a substantial shock to credit quality.7 An increase of NPLs to over 7 percent of total loans (doubling the NPLs), with a very conservative assumption of loss given default equal to 100 percent, would result in an aggregate loss of 21 percent of Tier I capital.8 Banks’ incomes would likely provide some additional buffer to offset the impact of such a shock.
The stress tests confirm the changing risk profile of the Slovak banking sector. A
comparison of the results based on end-September 2006 data with those of tests using data for previous years show that the exposure of Slovak banks to an increase in koruna interest rates has been increasing, largely because banks’ portfolios of fixed interest rate bonds with longer maturities have increased faster than the duration of their liabilities (Appendix 2). The
exposure to credit risk has been on a declining trend, reflecting the strengthening of banks’ balance sheets.
7 It should be noted that the magnitude of the assumed shocks under the stress tests for credit risk represents only a rough approximation of a possible deterioration in credit quality. Although the NBS has recently started developing a model capturing the relationship between macroeconomic variables, borrowers’ solvency, and banking losses, such a model is not yet robust due to the absence of time-series data covering the whole business cycle. The stress tests performed as part of the FSAP update should therefore be viewed only as indicative of how the banking sector might be affected by adverse credit shocks.
8 The assumption of loss given default of 100 percent is very conservative because many recently issued loans are well-collateralized mortgages, and the real estate market remains buoyant despite some stagnation in 2005.