Impact Story

Challenge:

The rapid growth of bank credit, fueled by strong economic activity during 2008-2011, had an impact on the quality of assets in the banking sector. At the end of December 2011, the ratio of nonperforming loans stood at 21 percent and banks' profitability ratios were negative owing to poor asset quality and the absence of important supporting preconditions such as information infrastructure (with no credit reference bureau, no collateral registry, and weak legal enforcement), as well as the lack of domestic securities and high operating costs. With the support of the IMF's long-term resident bank supervision expert, bank supervisors had made important progress in their capacity to carry out off-site and on-site supervision, with written procedures and templates for quarterly reporting, and a verification system was put in place to ensure the accuracy of information submitted by banks. To assess the vulnerability of the banking sector and to create in-house capacity for the underlying work, the Central Bank of Liberia (CBL) decided to embark on top-down stress testing. But there was no guideline or model, and the statistical base for risk analysis was inadequate. Aware of these important gaps, the CBL requested TA to help them to (i) strengthen the CBL's coverage and management of banking sector data for stress testing; (ii) develop an analytical framework to conduct stress tests on banks and assess banking sector vulnerabilities; (iii) train the regulators and supervisors in performing stress tests and interpreting results; and (iv) integrate stress testing into the regulator's off-site surveillance of banks. In support of this request, the IMF's Monetary and Capital Markets Department approached FIRST to seek funding for this project.

Solution:

With funding from FIRST, between August 2012 and July 2013, experts from the IMF's Monetary and Capital Markets Department fielded four missions to the CBL and provided the following TA: (i) assessed preparations at the CBL and commercial banks for adoption of stress testing and provided guidance on key issues and operational actions; (ii) developed and piloted a preliminary framework; (iii) strengthened the framework in terms of enhancing data quality, broadening risk coverage, and enhancing the plausibility of shocks and assumptions relating to stress testing; and (iv) evaluated the effectiveness of the TA in terms of enhanced capacity to assess banking sector vulnerabilities using top-down stress testing, in generating a well-informed financial stability analysis and reporting system.

Results:

Overall, the project was well received by the authorities and suited the particular circumstances of the CBL. The CBL has implemented most of the TA mission recommendations. Key achievements include the following:

(i)  A stress testing framework to run top-down stress tests to assess the vulnerability of the banking sector was developed and later enhanced using expanded data.

(ii)  Data collection efforts improved significantly. Notably, (a) there is greater and more in-depth scrutiny of prudential returns by the CBL staff; (b) the CBL is able to elicit more disclosures from the banks, thereby improving data quality and supervisory assessment; (c) the statistical base for risk assessment and analysis is strengthened and forms part of the compilation of a broader set of financial soundness indicators; (d) the CBL staff holds regular meetings with banks in order to obtain more information on their risk-management interfaces; and (e) the CBL is able to successfully conduct top-down stress testing and interpret the results to better inform its forward-looking financial stability analysis and reporting and its day-to-day supervisory actions.

(iii)  Stress testing capacity has been developed at the CBL; the staff now has the ability to conduct stress testing, monitor vulnerability, and provide advice to commercial banks as they move toward the adoption of their own stress tests.

(iv)  The CBL has started integrating stress testing in its macro- and micro-prudential analytical work as an additional tool for financial stability analysis and/or as early warning indicators, albeit on a limited basis.

(v)  The CBL has the framework in place as well as the necessary tools for the production of a financial stability report.

Furthermore, as a consequence of these reforms, the CBL is contemplating the possible establishment of a formal Financial Stability Unit to better manage banking sector vulnerability assessment, stress testing, and financial stability analysis and reporting