24 September 2013

ECB Working Paper: Bridging the banking sector with the real economy - A financial stability perspective

This paper examines the usefulness of a macro-prudential tool designed to assess whether the banking sector is adequately prepared to withstand losses resulting from normal or stressed macro- and micro-economic scenarios.

Authors Adrian Costeiu and Florian Neagu

The link between the banking sector and the real economy is established through the corporate sector channel. There are three additional uses for this tool for financial stability purposes: (i) to evaluate the overall and sectorial distribution of credit risk in the real economy; (ii) to gauge the trend of the overall default rate for the corporate sector, highlighting the most likely direction it will take in the banks' non-performing loan ratio; and (iii) to complement the macro-prudential approach with a micro-prudential perspective in order to compute the portfolio at risk of those entities that could put pressure on financial stability (e.g. systemically important institutions).

The tool has been developed in two steps. In the first step, a probability of default (PD) model for the corporate sector is built. The framework is established using micro data, with a bottom-up approach and is based on the Basel II definition of default (90-days past due date). The purpose of this experiment is to outline the main micro-economic factors that best explain companies' behaviour in servicing their banks' debts.

The second step is to bridge the PD corporate model with a macro-economic module in order to capture the feedback effects of the macro-economic stance on the banking sector. Authors examine the ways in which the main macro-economic variables (annual GDP growth, real effective exchange rate, inflation rate, etc.) could impact corporate PD results. The module allows authors to evaluate the ability of the companies in the banks' portfolio to withstand normal or stressed macro-economic scenarios.

The new PD, adjusted in line with the macro-economic stance, is used to estimate the expected losses that a banking sector would face as a result of its corporate sector portfolio. The gap between the expected losses and the prudential buffers already in place to shield such losses is thereby determined. Authors then assess whether this gap could be dealt with in an orderly manner, so as to avoid putting undue pressure on financial stability.

This tool is tested on the Romanian economy. The main micro-economic factors identified as hindering the corporate sector from servicing its debt are a deterioration in the receivables turnover ratio, sales-to-total assets ratio, short-term bank debt-to-total assets and debtto-equity, while the macro-economic factors affecting the corporate default rate are annual GDP growth, a change in the real effective exchange rate, CORE1 annual inflation rate and the FX interest rate spread. It is revealed that the banking sector under review is in relatively good shape in order to withstand developments stemming from the explored scenario, the up-trending level of provisioning being rather easy to accommodate in an orderly manner.

Working paper

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