Central Bank of Jordan Circular on Stress Testing Requirements for Banks (2021 Data)

CENTRAL BANK OF JORDAN البنك المركزي الأردني

Stress Testing Requirements for Banks Based on End-of-Year 2021 Data

First: Tests on the Impact of the Corona Pandemic and Global Geopolitical Tensions

Banks must conduct the following tests regarding the impact of the Corona pandemic and global geopolitical tensions, calculating the impact on non-performing loans (NPLs), provisions, profits, regulatory capital adequacy ratio¹, and Tier 1 capital¹:

• Test 1: A 100% increase in direct non-performing facilities across all economic sectors.
• Test 2: 10% of facilities that were subject to payment deferral, restructuring, or rescheduling by the bank due to effects related to the Corona pandemic default, classifying these facilities as non-performing.
• Test 3: 20% of facilities that were subject to payment deferral, restructuring, or rescheduling by the bank due to effects related to the Corona pandemic default, classifying these facilities as non-performing.

In addition to the tests mentioned above, banks must calculate the impact of the following scenarios (Multi-Factor shock) on non-performing loans, provisions, profits, and capital adequacy ratios:

• Medium Intensity Scenario:

  1. 25% of facilities granted to the tourism, transport, and wholesale importers of basic commodities sectors default, classifying the facilities granted to them as non-performing.
  2. 5% of facilities granted to individuals default, classifying the facilities granted to them as non-performing.
  3. A 20% decrease in the price of stocks invested in by the bank.
  4. A 20% decrease in the profits of the bank's branches and its foreign subsidiaries (for banks that have foreign branches or subsidiaries).

• Severe Intensity Scenario:

  1. 50% of facilities granted to the tourism, transport, and wholesale importers of basic commodities sectors default, classifying the facilities granted to them as non-performing.
  2. 10% of facilities granted to individuals default, classifying the facilities granted to them as non-performing.
  3. A 40% decrease in the price of stocks invested in by the bank.
  4. A 40% decrease in the profits of the bank's branches and its foreign subsidiaries (for banks that have foreign branches or subsidiaries).

Second: Climate Risk Tests

Climate change is one of the most important risks and challenges facing various countries in the world currently due to its wide-ranging impacts on various economic sectors borrowing from banks, which increases the likelihood of rising credit risks. Banks must conduct the following tests related to two main types of climate change risks:

A. Physical Risks These are losses resulting from climate change and extreme environmental events such as: earthquakes, volcanoes, floods, droughts, and global warming, etc. The bank must conduct a test regarding the impact of extreme weather phenomena that could cause the bank to incur physical losses.

In addition to the above test, the bank must conduct the following tests related to the occurrence of extreme weather phenomena on the following economic sectors:

Test 1: A portion of facilities granted to the industrial sector defaults due to an increase in physical risk events related to climate change, classifying the credit for the sector as non-performing as follows:

Assumption	Default Rate
Medium Intensity	10%
Severe Intensity	20%

Test 2: A portion of facilities granted to the agricultural sector defaults due to an increase in physical risk events related to climate change, classifying the credit for the sector as non-performing as follows:

Assumption	Default Rate
Medium Intensity	10%
Severe Intensity	20%

Test 3: A portion of facilities granted to the tourism, hotels, and restaurants sector defaults due to an increase in physical risk events related to climate change, classifying the credit granted to the sector as non-performing as follows:

Assumption	Default Rate
Medium Intensity	10%
Severe Intensity	20%

Test 4: A portion of facilities granted to the three sectors mentioned above (industry, agriculture, and tourism, hotels, and restaurants) defaults due to an increase in physical risk events related to climate change, classifying the credit granted to the three sectors as non-performing as follows:

Assumption	Default Rate
Medium Intensity	10%
Severe Intensity	20%

B. Transition Risks These are losses resulting from the transition from a carbon-intensive economy to a low-carbon economy due to increased reliance on renewable energy sources as a result of efforts to combat climate change. The bank must conduct the following tests:

Test 1: 5% of facilities granted to companies with high carbon emissions, such as mining companies and petrochemical companies, default, classifying the credit granted to these companies as non-performing.

Test 2: 10% of facilities granted to companies with high carbon emissions, such as mining companies and petrochemical companies, default, classifying the credit granted to these companies as non-performing.

Third: Credit Concentration Risk Tests

Test 1: Default of the bank's largest borrowers (excluding Jordanian government facilities and facilities guaranteed by the government), classifying the credit granted to them as non-performing as follows:

Assumption	Default
Moderate Intensity	Default of the largest borrower
Medium Intensity	Default of the top 3 borrowers
Severe Intensity	Default of the top 6 borrowers

Note: Banks must attach a statement of the names and values of facilities granted to the top six borrowers (excluding Jordanian government facilities and facilities guaranteed by the government) used in applying the above tests.

Test 2: Default of the bank's largest borrowers (excluding Jordanian government facilities, facilities guaranteed by the government, and facilities of the Jordanian Oil Refinery Company and electricity companies), classifying the credit granted to them as non-performing as follows:

Assumption	Default
Moderate Intensity	Default of the largest borrower
Medium Intensity	Default of the top 3 borrowers
Severe Intensity	Default of the top 6 borrowers

Note: Banks must attach a statement of the names and values of facilities granted to the top six borrowers (excluding Jordanian government facilities, facilities guaranteed by the government, and facilities of the Jordanian Oil Refinery Company and electricity companies) used in applying the above tests.

Test 3: Increase in direct non-performing facilities for the top five economic sectors receiving direct facilities from the bank.

Assumption	Increase Rate
Moderate Intensity	10%
Medium Intensity	25%
Severe Intensity	50%

Test 4: Increase in direct non-performing facilities for the real estate sector.

Assumption	Increase Rate
Moderate Intensity	10%
Medium Intensity	25%
Severe Intensity	50%

Fourth: Market Risk Tests

The primary objective of conducting sensitivity analysis tests for market risks is to determine the impact of potential changes in market prices on profits and losses, and subsequently on the regulatory capital adequacy ratio² and Tier 1 capital² of the bank. The bank must conduct the following tests:

Shock 1: Exchange Rate Risk:

• Decrease in the exchange rate of the Dinar:

Assumption	Decrease
Moderate Intensity	Decrease in the Jordanian Dinar exchange rate by 15% against other currencies
Medium Intensity	Decrease in the Jordanian Dinar exchange rate by 20% against other currencies
Severe Intensity	Decrease in the Jordanian Dinar exchange rate by 25% against other currencies

• Increase in the exchange rate of the Dinar:

Assumption	Increase
Moderate Intensity	Increase in the Jordanian Dinar exchange rate by 15% against other currencies
Medium Intensity	Increase in the Jordanian Dinar exchange rate by 20% against other currencies
Severe Intensity	Increase in the Jordanian Dinar exchange rate by 25% against other currencies

Shock 2: Interest Rate Risk: Changes in market interest rates can negatively affect the bank's financial position through their direct impact on the bank's revenues (net interest income) as well as the medium to long-term impact on the market value of the bank's assets and liabilities, which are affected by the interest rate.

Sensitivity tests regarding interest rates are applied to all instruments carrying variable or fixed interest rates, whether classified in the banking book or trading book. Gap analysis tests are conducted as follows:

• Gap Analysis Tests³: These tests aim to determine the bank's position regarding the balance of assets and liabilities sensitive to interest rate risks. Within these tests, the following are conducted:

Assumption	Increase/Decrease
Moderate Intensity	Increase in interest rates by 100 basis points
Medium Intensity	Increase in interest rates by 150 basis points
Severe Intensity	Increase in interest rates by 200 basis points

Shock 3: Stock Price Decline Risk, where the following tests must be conducted:

Assumption	Decrease
Moderate Intensity	Decrease in the price of stocks invested in by the bank by 10%
Medium Intensity	Decrease in the price of stocks invested in by the bank by 20%
Severe Intensity	Decrease in the price of stocks invested in by the bank by 30%

Fifth: Liquidity Risk Tests The availability of sufficient liquidity at the bank depends largely on its ability to meet its obligations during financial crises. In addition to the necessity for the bank to conduct cash flow projections to determine cash requirements under normal operating conditions, the bank must conduct stress tests through cash flow projections based on "What if" scenarios and measure their impact on the bank's liquidity. In this regard, the bank must conduct the following tests:

Outflow Tests⁴:

• Withdrawal of a portion of stable individual deposits⁴:

Assumption	Decrease
Moderate Intensity	Withdrawal of a portion of stable individual deposits by 5%
Medium Intensity	Withdrawal of a portion of stable individual deposits by 10%
Severe Intensity	Withdrawal of a portion of stable individual deposits by 20%

• Withdrawal of a portion of unstable individual deposits:

Assumption	Decrease
Moderate Intensity	Withdrawal of a portion of unstable individual deposits by 10%
Medium Intensity	Withdrawal of a portion of unstable individual deposits by 20%
Severe Intensity	Withdrawal of a portion of unstable individual deposits by 30%

• Withdrawal of a portion of stable corporate deposits:

Assumption	Decrease
Moderate Intensity	Withdrawal of a portion of stable corporate deposits by 5%
Medium Intensity	Withdrawal of a portion of stable corporate deposits by 10%
Severe Intensity	Withdrawal of a portion of stable corporate deposits by 20%

• Withdrawal of a portion of unstable corporate deposits:

Assumption	Decrease
Moderate Intensity	Withdrawal of a portion of unstable corporate deposits by 10%
Medium Intensity	Withdrawal of a portion of unstable corporate deposits by 20%
Severe Intensity	Withdrawal of a portion of unstable corporate deposits by 30%

• Withdrawal of a portion of unused limits from facilities for individuals and small companies:

Assumption	Decrease
Moderate Intensity	Withdrawal of a portion of unused limits from facilities for individuals and small companies by 5%
Medium Intensity	Withdrawal of a portion of unused limits from facilities for individuals and small companies by 10%
Severe Intensity	Withdrawal of a portion of unused limits from facilities for individuals and small companies by 20%

• Withdrawal of a portion of unused limits from non-financial corporate facilities:

Assumption	Decrease
Moderate Intensity	Withdrawal of a portion of unused limits from non-financial corporate facilities by 10%
Medium Intensity	Withdrawal of a portion of unused limits from non-financial corporate facilities by 20%
Severe Intensity	Withdrawal of a portion of unused limits from non-financial corporate facilities by 40%

• Withdrawal of a portion of unused limits from financial corporate facilities:

Assumption	Decrease
Moderate Intensity	Withdrawal of a portion of unused limits from financial corporate facilities by 40%
Medium Intensity	Withdrawal of a portion of unused limits from financial corporate facilities by 80%
Severe Intensity	Withdrawal of a portion of unused limits from financial corporate facilities by 100%

• Withdrawal of the largest deposits:

Assumption	Decrease
Moderate Intensity	Withdrawal of the largest deposit
Medium Intensity	Withdrawal of the top three deposits
Severe Intensity	Withdrawal of the top five deposits

Note: Banks must attach a statement of the names and values of the top five deposits at the bank along with the results of applying the withdrawal of the largest deposits test.

• Decrease in liquid assets:

Assumption	Decrease
Moderate Intensity	Decrease in the bank's liquid assets by 5%
Medium Intensity	Decrease in the bank's liquid assets by 10%
Severe Intensity	Decrease in the bank's liquid assets by 20%

Sixth: Operational Risk Tests Regarding operational risk tests, the bank must set at least one hypothesis for potential operational events and measure their impact on the bank's profitability and regulatory capital adequacy ratio⁵ and Tier 1 capital⁵. These tests must include:

• A test on the probability of increased cyberattacks due to the likelihood of increasing cyber risks resulting from increased reliance on financial technology and increased use of electronic payment methods accelerated by the Corona pandemic.
• Two tests on the probability of armed robbery at one of the bank's branches, internal fraud, fire in bank buildings, or the bank losing some lawsuits filed against it, or changes in correspondent bank behavior or supervisory action affecting the bank's reputation, such as imposing a penalty on the bank by the supervisory authority in the home or host country due to the bank's fundamental violation of any laws, regulations, or instructions, or engaging in unsafe or unsound banking practices, etc.

Seventh: Additional Stress Tests In addition to the tests specified above, the bank must conduct additional tests commensurate with the size and nature of the risks it faces, with no less than one additional test for each type of risk mentioned above.

Eighth: Scenario Tests Medium and severe macro scenarios represent hypothetical cases designed to evaluate banks' ability to withstand shocks. Assuming an increase in the intensity of global geopolitical tensions and the challenges they pose to the national economy, and the continuation of some negative repercussions of the Corona virus, which may lead to a significant decline in economic growth rates compared to expectations and an increase in unemployment and a decline in the financial market. We also assumed the continued rise in interest rates to maintain the attractiveness of the Jordanian Dinar as a savings currency. To measure the impact of these assumptions on banks, the Gross Domestic Product (GDP) growth rate (economic growth rate) is usually used as one of the main economic variables affecting non-performing loans, and the impact on the regulatory capital adequacy ratio⁶ and Tier 1 capital⁶ of the bank is measured. Economic research indicates that a decrease in the economic growth rate leads to an increase in non-performing loans due to the decline in economic activity and thus the decline in customers' ability to repay their debts. Other variables such as interest rates, unemployment rate, and inflation rate can also be used to predict non-performing loans.

To predict the non-performing loan ratio for the coming year, a Multiple Regression Analysis methodology is used according to the following model:

NPL = β0 + β1NPL(-1) + β2X1 + β3X2 + ... + βnXn + e

Where: NPL: Expected non-performing loan ratio as of the end of 2022. β0: Constant. NPL(-1): Non-performing loan ratio for the previous year (as of the end of 2021). X1-Xn: Macroeconomic variables used to predict the non-performing loan ratio (e.g., economic growth rate, interest rates, unemployment rate, inflation rate, etc.). β1-βn: Regression Coefficients.

In this regard, banks must conduct the following scenarios, noting that the Central Bank will provide banks with the required scenarios annually, which may differ from year to year.

a- Baseline Scenario: In this scenario, to determine the values of macroeconomic variables, the Jordanian Central Bank's expectations were relied upon, as shown in Annex No. (3).

b- Medium Macro Stress Scenario: A decrease in the economic growth rate in the Kingdom in 2022 to -0.2%, an increase in the unemployment rate to 27.2%, an increase in the inflation rate to 5.9%, and an increase in interest rates by 100 basis points.

c- Severe Macro Stress Scenario: A decrease in the economic growth rate in the Kingdom in 2022 to -2.6%, an increase in the unemployment rate to 30.2%, an increase in the inflation rate to 8.8%, and an increase in interest rates by 200 basis points.

Note that the following methodology was used to arrive at the above percentages: Medium Macro Stress Scenario: The expected economic growth rate for 2022 minus one standard deviation of the economic growth rate data during the period (1994-2021), the unemployment rate for 2021 plus one standard deviation of the unemployment rate data during the period (1994-2021), and the expected inflation rate for 2022 plus one standard deviation during the period (1994-2021). Severe Macro Stress Scenario: The expected economic growth rate for 2022 minus two standard deviations of the economic growth rate data during the period (1994-2021), the unemployment rate for 2021 plus two standard deviations of the unemployment rate data during the period (1994-2021), and the expected inflation rate for 2022 plus two standard deviations of the inflation data during the period (1994-2021). Regarding interest rates, the percentages were graduated with reference to the assumptions used in the Instructions on Stress Testing for Banks Operating in Jordan No. (2016/1) dated 2016/12/6, and Basel Committee guidelines regarding the standard shock for interest rate risk.

• Annexes

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Annex No. (1): Sensitivity Test Models

Model No. 1: Tests on the Impact of the Corona Pandemic and Global Geopolitical Tensions

Shock Intensity	Before Shock	After Shock	Additional Provisions Resulting from Applying the Shock	Profit/Loss Adequacy Ratio	Capital Adequacy Ratio	Tier 1 Capital Adequacy Ratio
	Profit/Loss	Capital	Regulatory Capital	Tier 1 Capital	Risk-Weighted Assets	NPL Provisions
Test 1: Increase in direct non-performing facilities by 100% across all economic sectors.