Macro-stress tests of the pension management companies sector
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1 Macro-stress tests of the pension management companies sector he CNB uses macro-stress tests of the pension management companies (PMC) sector as a tool for assessing the sector s resilience to possible adverse shocs. ll domestic pension management companies participate in the test. he test methodology is based on the nature of business in this sector. he proposed shocs therefore arise from a decline in the value of the assets of transformed funds (Fs) due to adverse financial maret developments. Owing to the statutory duty of a PMC to top up the funds in F it manages the simulated shoc affects its capitalisation. Stress test scenarios s with the stress testing of bans 1 and insurance companies alternative macroeconomic scenarios are the starting point for the PMC stress tests. he scenarios are designed using the CNB s official prediction model supplemented with an estimate of the evolution of some additional variables which are not directly generated by the model. macroeconomic stress scenario is constructed based on the identification of riss that are typical of the Czech financial system or are imminent in the next few periods. Moreover to compare the stress outcome with the most probable outcome the stress tests also use a baseline macroeconomic scenario based on the current official macroeconomic prediction of the CNB. able 1 Illustration of macroeconomic stress scenarios (end-period values) Macroeconomic developments ctual +1Q +2Q +3Q +4Q +1Q +2Q +3Q +4Q GDP (y-o-y %*) CZK/EUR exchange rate 27.6 ** ** ** ** Inflation (%) Unemployment (%) Nominal w age grow th (%) Effective euro area GDP grow th (%) sset marets (%) Baseline scenario Stress scenario 3M PRIBOR M EURIBOR Note: * Year-on-year increase compared to the same quarter a year earlier. denotes the reference quarter. ** Values in the Baseline scenario are currentlynot published due to the use of the oruna exchange rate as an additional monetary policy instrument. In the stress tests the prediction for financial variables at a horizon of four quarters consistent with the relevant macroeconomic scenario is reflected directly in the value of the F s assets. Specifically the value of the F s assets changes depending on changes in interest rates (interest rate ris) the exchange rate (exchange rate ris) maret prices of equity securities (equity ris) and the value of real estate investments (real estate ris). he test is one-off ( what-if ) in nature. he revaluation of the F s assets is thus immediate and 1 Baning sector stress test methodology
2 uses the value expected in the scenario four quarters from the start of the test (i.e. consistent with the +4Q column in able 1). 2 Riss assessed in the stress test Interest rate ris Given the structure of Fs portfolios interest rate ris is the most important area of stress testing. ll debt securities held by Fs are subject to this ris. wo types of interest rate ris are taen into account: 1. General interest rate ris the ris of a change in the maret price of an asset due to a change in the maret interest rates used to value cash flows arising from ownership of the asset. 2. Specific interest rate ris the ris of a change in the maret price of an asset due to a change in the credit rating of its issuer. In other words the ris of a change in the ris premium of the asset as perceived by financial marets. ll debt securities other than those held to maturity are subject to general interest rate ris. he exception for the held-to-maturity portfolio is based on accounting rules under which this portfolio is not mared to maret and is thus immune to changes in maret interest rates. F may only include OECD government bonds of the same or higher rating than that of Czech government bonds in its held-to-maturity portfolio. he size of this portfolio may not exceed 35% of the F s assets. 3 he impact of the realisation of general interest rate ris on the value of the F s debt securities is calculated separately for each issue in the portfolio. he original value of an issue is determined by discounting the cash flows arising from it using the swap curves valid as of the reference date (i.e. the start of the test ). he new value of the issue is determined by discounting these cash flows using the swap curves assumed in the scenario (see able 2). 4 he materialisation of general interest rate ris is then given by the difference between the two values. If for example interest rates increase across the yield curve the price of the debt security decreases because the payments on the asset are lower in value than the current rates. Generally the larger the rise in the yield curve or the longer the residual maturity (more precisely duration) of the issue the greater the decline in the price. 5 he change in the oruna swap curve is used for oruna-denominated debt securities. he change in the euro swap curve is used for debt securities denominated in other currencies (mostly EUR for Fs). he swap curve scenario is based on the forecast for the three-month PRIBOR or EURIBOR and also on the forecast for one-year five-year and ten-year rates on interest rate swaps. Interpolation is used to determine the rates for other maturities of up to 10 years. Rates for 2 It is thus assumed that the F does not change the size and structure of its assets portfolio over the test horizon. Exposures to interest rate exchange rate real estate and equity ris thus remain constant (the static balance sheet assumption ). 3 his does not mean however that the F may not hold a larger volume of government bonds to maturity than the limit of 35% of its assets. It is only prohibited from reporting the above-limit part of government bonds as held to maturity for valuation purposes and must mar them to maret. 4 he exchange rate as of the start of the test is used for debt securities (or derivatives interest payment legs) denominated in foreign currency. 5 he information needed to determine the distribution of cash flows i.e. the time to maturity the coupon frequency the time to the next coupon the type of coupon and the coupon rate is obtained from the Bloomberg system. he principal is obtained from the regular reports submitted by the F.
3 maturities of over 10 years are derived by assuming a flat forward curve from 10 years upwards and the forward rate is based on the five-year and ten-year swap rates. 6 able 2 Illustration of scenarios for a general interest rate shoc (swap curve in % p.a.) +4Q Maturity (years) Baseline scenario dverse scenario CZK EUR CZK EUR CZK EUR Calculation technique for general interest rate ris for a debt security he change in the value of the debt security is calculated as Y ) ( Y ) 4Q ( currency 4Q currency K C ( Ycurrency ) and 1 1 Y ( t ) 4Q ( Y currency 4Q ) t t Y ( t ) t t K 1 1 currency currency t t Y ( t ) t t currency 4Q C Y t currency 4Q ( Y currency ) is the value of the asset as of the reference date as a function of the swap curve in the relevant currency as of the reference date ( Y ). Y ) is the currency ( t ) t 4Q ( currency 4Q value of the asset following the application of the shoc as a function of the swap curve assumed in the scenario ( Ycurrency 4Q ). he yield curves Ycurrency are shown in able 2. Symbols and denote the nearest higher and lower integer maturity. denotes the serial number of a payment on the debt security of amount C occurring t years after the reference date. For a floating rate bond K 1 and payment C1 is the sum of the principal and the coupon determined on the basis of the last setting of the coupon payment (the rate reset ). specific correction coefficient is applied to each security to ensure that the value of the security as of the reference date ) regulatory reporting. ( Y currency equals the valuation of the security in the F. 6 If this assumption were to result in an unusual yield curve course an expert adjustment would be made.
4 ll debt securities without exception are subject to specific interest rate ris as a worsened credit appraisal can also affect the value of securities held to maturity. heir lower sensitivity to maret fluctuations is reflected in the application of only 20% of the shoc. he impact of the realisation of specific interest rate ris on the value of the F s debt securities is calculated separately for each issue in the portfolio. It is based on the maret value of the issue as of the reference date and the relative devaluation rate considered in the scenario which corresponds to the rating and residual maturity of the issue (see able 3). 7 Generally a higher devaluation rate corresponds to lower rating and longer residual maturity. able 3 Illustration of an adverse scenario for a specific interest rate shoc (percentage change in asset value between and +4Q) Investment grade Speculative grade BBB BB or lower No rating 0 1Y >1 3Y >3 5Y >5 7Y >7 10Y >10Y he relative devaluation rate is applied separately to government securities and to other debt securities. he devaluation for oruna government securities is determined using the forecast for the yield on five-year and ten-year Czech government bonds. 8 he devaluation for foreign currency government securities of the highest credit quality is determined using the forecast for the yield on five-year and ten-year German government bonds. n additional haircut corresponding to the issuer s credit rating is applied to bonds of other countries. In simple terms higher devaluation is applied to government bonds of worse credit quality. he relative devaluation rate for corporate debt securities is the sum of the shoc to the price of government bonds of the corporation s home country (i.e. the shoc from the previous paragraph) and an additional haircut corresponding to the corporation s rating taing into account the residual maturity of the issue. Calculation technique for specific interest rate ris for a debt security he change in the value of the debt security is calculated as maturity rating shoc maturity rating maturity rating 4Q maturity rating maturity rating maturity rating is the value of the asset and shoc scenario maturity rating scenario maturity rating is the coefficient for the relevant residual maturity bucet and rating in able 3. he tables of shocs are different for corporate and government debt securities. 7 he method for setting scenarios for a specific interest rate shoc is currently being revised. 8 It is set in the following manner. First swap curves and government bond yield curves are constructed. hen the change in the credit spread i.e. the change in the difference between the government bond yield and the swap rate compared to the reference date is calculated for the maturity corresponding to the centre of the maturity band (see able 3; for the last maturity band of 12 years). he size of the devaluation considered (i.e. the value in able 3) is the change in the credit spread after multiplication by 70% of the centre of the maturity band in years.
5 he test taes into account hedging by the F against general interest rate ris. Interest swaps (IRS or cross-currency swaps) negotiated by the F are mared to maret by discounting payments arising from derivatives using swap curves analogously to the revaluation of debt securities. he total change in the value of the F s assets due to interest rate ris is the sum of the changes in the values of the relevant debt securities and derivatives in the F s portfolio. Exchange rate ris ll ban deposits and debt and equity securities denominated in foreign currency are subject to exchange rate ris. If in the scenario the foreign currency appreciates the oruna value of foreign currency assets generally rises. Conversely a oruna appreciation is associated with a fall in the oruna value of foreign currency assets. For deposits and equity securities the change in the exchange rate in the scenario is applied to the oruna value of the foreign currency exposure reported as of the reference date. For debt securities which are affected jointly by exchange rate and interest rate ris the exchange rate shoc is only applied to the oruna value of the issue after the general interest rate shoc has been applied. Calculation technique for exchange rate ris of a debt security he change in the value of the relevant asset is calculated as S CZK / EUR 4Q S CZK ( S CZK / EUR Ycurrency 4Q ) SRCZK S CZK / EUR CZK / EUR CZK is the oruna value of the exposure as a function of the exchange rate S CZK / EUR and the swap curve Ycurrency able 1 and the swap curve in able 2 are used. in the relevant currency of the exposure. he exchange rates in SR CZK is the impact of specific interest rate ris on the value of the asset and is the previously described correction coefficient. he test taes into account derivative hedging of the exposure against exchange rate ris. Foreign currency derivatives are mared to maret by discounting payments arising from the derivative using swap curves. In the case of currency forwards and FX swaps the initial value is calculated using the swap curves and exchange rate applicable as of the reference date. In the case of CCS swaps the initial value is calculated using the swap curves assumed in the scenario (i.e. after the general interest rate shoc is applied) and the exchange rate as of the reference date so to avoid double counting of part of the interest rate shoc. he new value is then set for all derivatives using the swap curves and exchange rate assumed in the scenario. he change in asset value due to exchange rate ris is the sum of the changes in the values of the relevant ban deposits securities and derivatives in the F s portfolio. s the majority of Fs foreign currency exposures are euro-denominated the stress test primarily uses the CZK/EUR exchange rate derived by the CNB s official prediction model (see able 1). he appreciation (depreciation) of the oruna against other currencies is then assumed to be proportional to the appreciation (depreciation) of the oruna against the euro. Equity and real estate ris he change in the value of the F s investments in equity securities and real estate is calculated as the difference in the value of exposures as of the reference date and the value of exposures after the application of coefficients of growth (decline) in prices of the relevant types of assets assumed in the scenario (see able 4).
6 able 4 Illustration of scenarios for equity and property shocs (percentage change in asset value between and +4Q) Baseline scenario dverse scenario Equity ris Equity securities of EE/OECD countries Equity securities of other countries Real estate ris Real estate exposures Calculation technique for equity ris and real estate ris he change in asset value is calculated as type type type 4Q type type shoctype scenario type is the value of the investments and type scenario particular asset type and scenario in able 4. Profit/loss of the F shoc is the coefficient for the he F s profit/loss for the relevant accounting period is calculated in the stress test. his consists of its boo returns on asset holdings net of its costs in the accounting period. However the boo returns on asset holdings are not equal to the change in asset value in the relevant period. he change in asset value only enters the profit/loss if the gain or loss on the asset (for example coupons dividends profit/loss from sales returns on matured assets) is actually realised in the relevant period. he change in the value of assets that are associated with unrealised gains in the relevant period i.e. that were only mared to maret is reported under revaluation changes. he stress test currently assumes that 85% of the change in asset value due to the stress test enters revaluation changes and 15% enters the F s profit/loss. 9 s regards the calculation of the realised gain directly entering the F s profit/loss the complexity of the calculation (estimates of the size of coupons dividends and income on the held-to-maturity portfolio or cost items) means that approximations have to be used. he value of asset holdings as of the reference date is multiplied by the average return on assets (net profit divided by asset value) in the F sector in the previous periods. his technique is used to estimate the profit the F would have recorded had maret prices of assets not changed in the stress test. wo values thus enter the total profit/loss of the F: 15% of the change in asset value due to the stress test and the estimated realised gain described above. Impact on the pension management company he F s profit/loss has a direct lin to its PMC. If the F maes a profit the PMC may claim up to 10% of that profit. he stress test assumes that the PMC withdraws the maximum amount. If a loss is generated it is not carried over to the profit/loss of the PMC. he duty of 9 hese figures are based on the current structure of portfolios of Fs in the Czech Republic. If that were to change the assumption could also change.
7 a PMC to top up the funds of the F it manages arises only if the total value of the assets held by the F is lower than the value of its liabilities (primarily to the F s clients). he test therefore compares the value of the F s assets at the end of the stress test with the value of the F s liabilities. he final value of the F s assets is equal to the value of the F s assets as of the reference date (the start of the test) after addition of the average return after the application of shocs and after deduction of any part of the F s profit withdrawn by the PMC. he final value of the F s liabilities is equal to the value of the F s liabilities as of the reference date after addition of the remainder of the F s profit/loss. ny profit is divided among the F s clients. he sum which the PMC should pay to the F is determined from the difference between the final values of the F s assets and liabilities. his amount is then deducted from the PMC s capital (Figure 1 situation ). If the PMC s available capital falls below the minimum capital requirement the PMC s capital must be topped up (Figure 1 situation ). Figure 1 ransmission of a shoc from a transformed fund to a pension management company Situation ransformed fund Pension management company he decline in asset value... Revaluation gains/losses to plan members and other liabilities to plan members and other liabilities...results in a need for the PMC to top up the F resources... Capital...which reduces the PMC s capital + 0 Revaluation gains/losses Capital Before fter Before fter Before fter
8 + 0 Situation B ransformed fund he decline in asset value... Revaluation gains/losses Pension management company...is not large enough to cause the value of assets to drop below the value of to plan to plan liabilities of the members members F. he PMC and other and other thus does not liabilities liabilities need to top up Capital Capital thef resources......so the PMC s capital is not affected Before fter Before fter Before fter Calculation technique for the impact of the stress test on the pension management company s capital In the stress test the impact of the scenario on the PMC s available capital K PS calculated as K 01 Z ;0 min L ;0 PS max F F 4Q F 4Q and Z is the F s profit/loss recorded in the one-year stress test period and F 4Q F LF 4Q are the values of the F s assets and liabilities respectively at the end of the test. hese variables are determined using the following relations: Z r L F F 1 r max01 Z ;0 09 Z ;0 F 4Q F F L max F 4Q F F F and L F are the values as of the reference date r is the average return on assets and is the change in asset value due to the materialization of interest rate exchange rate equity and real estate ris. he scenario affects not only the PMC s available capital but also its capital requirement. s the value of the assets in the F decreases (increases) the value of the minimum capital which the PMC is required to hold in respect of those assets decreases (increases). s regards the components of the capital requirement the test considers the change in the capital requirements for assets in the F and for the riss of the F. 10 In simple terms the change in these requirements is proportional to the change in the value of the relevant assets. he other components of the capital requirement the requirement for assets in other funds and operating costs are treated as constant in the test. 11 is 10 he calculation of the capital requirement for the riss of the F abstracts from assessing whether items with preferential ris weights meet the requirement for a country rating at least comparable to that of the Czech Republic. 11 he calculation completely abstracts from the additional capital requirements for the second and third pension system pillars due to ongoing legislative changes and to their minimal size.
9 he main conclusion of the stress test is an assessment of how many PMCs will record a fall in capital below the capital requirement and what amount the PMC s shareholders will have to inject to restore the PMC s capital to at least the minimum statutory level. Prepared by the CNB s Financial Stability Department. Contact: financial.stability@cnb.cz
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