Circular on Stress Testing and Sensitivity Analysis for Banks in Jordan

1 1614/2/23 H 1439/05/14 M 2018/01/31 Circular to Banks Operating in the Kingdom

With best regards,

Pursuant to Instruction No. (2016/1) on Stress Testing for Banks in Jordan, and based on the attached sensitivity analysis tests and scenarios, banks are required to conduct tests on data as of the end of 2017. This should be done at the level of the Central Bank of Jordan branches and on the consolidated financial data level, such that the application of sensitivity tests is limited only to the Central Bank of Jordan branches. The Central Bank expects to receive the results of the required tests at the branch level, according to the attached forms, no later than the end of March 2018. Banks will continue to provide the required tests annually, taking into account risk developments at the local, regional, and international levels.

With highest respect and acceptance,

Governor Dr. Ziad Al-Fraiz

2

Based on data as of the end of 2017, the required stress tests from banks are:

First: Sensitivity Analysis Tests

A. Credit Risk These tests aim to measure the impact of the economic cycle, in addition to factors specific to the bank, that could lead to an increase in credit risk at the bank, thereby affecting the bank's profitability and the ratio of regulatory capital adequacy to basic capital.

1. First Shock: Increase in Indirect Facilities Assumed Increase Ratio:

• Moderate Intensity: 50%
• Medium Intensity: 100%
• Severe Intensity: 150%

2. Second Shock: Increase in Indirect Facilities for the Five Largest Economic Sectors Holding Direct Facilities from the Bank Assumed Increase Ratio:

• Moderate Intensity: 10%
• Medium Intensity: 25%
• Severe Intensity: 50%

3. Third Shock: Increase in Indirect Facilities Granted to the Real Estate Sector Assumed Increase Ratio:

• Moderate Intensity: 10%
• Medium Intensity: 25%
• Severe Intensity: 50%

4. Fourth Shock: Default of the Largest Borrowers (Excluding Facilities Guaranteed by the Jordanian Government and classified as credit to them) Assumed Default:

• Moderate Intensity: Default of 1 largest borrower
• Medium Intensity: Default of 3 largest borrowers
• Severe Intensity: Default of 6 largest borrowers

5. Fifth Shock: Decrease in the Value of Collateral Placed Against Indirect Facilities Assumed Decrease Ratio:

• Moderate Intensity: 10%
• Medium Intensity: 20%
• Severe Intensity: 30%

B. Market Risk The main objective of conducting market risk sensitivity analysis tests is to know the potential changes in market prices and their impact on profits and losses, and then on the regulatory capital adequacy ratio.

The bank is required to conduct the following tests:

1. First Shock: Exchange Rate Risk

• Decrease in the Exchange Rate of the Jordanian Dinar:

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

• Increase in the Exchange Rate of the Jordanian Dinar:

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

2. Second Shock: Interest Rate Risk Changes in interest rates in the market that could negatively affect the bank's financial position, including a direct impact on the bank's net interest income, as well as a medium to long-term impact on the market value of the bank's assets and liabilities.

Sensitivity tests are applied to instruments subject to interest rates, whether classified in the trading portfolio or the banking portfolio, fixed or variable.

The specific tests are conducted by analyzing gaps:

Gap Analysis Tests: These tests aim to determine the bank's position regarding interest rate risk-sensitive assets and liabilities. The following assumptions are made:

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

3. Third Shock: Equity Price Decrease Risk The bank is required to conduct the following tests: Assumed Decrease:

• Moderate Intensity: Decrease in equity prices held by the bank's investors by 10%
• Medium Intensity: Decrease in equity prices held by the bank's investors by 20%
• Severe Intensity: Decrease in equity prices held by the bank's investors by 30%

3. Repricing risk is one of the most prominent interest rate risks, resulting from differences in maturity dates (fixed interest rates) or repricing dates (variable interest rates). For example, if the bank finances long-term fixed-interest loans using short-term variable-interest deposits, the bank will face a decline in future income if interest rates rise. This decline is due to the cash flows from the long-term fixed loan being higher than the interest paid on the deposit. The test begins by determining a schedule for distributing interest-rate-sensitive assets and liabilities (variable interest rates) and maturity dates (fixed interest rates) according to time periods, thereby determining the impact of interest rate decreases on the bank's profits and value.

4. Liquidity Risk Liquidity risk depends significantly on the bank's ability to meet its obligations. In addition, the bank must conduct cash flow projections under normal operating conditions to determine cash requirements and outflows. These projections are based on "What if" stress scenarios. Specifically, the bank is required to conduct tests to measure the impact on the bank's liquidity:

5. Outflows Tests:

• Withdrawal of a portion of Stable Individual Deposits:

  • Moderate Intensity: Withdrawal of 5% of stable individual deposits
  • Medium Intensity: Withdrawal of 10% of stable individual deposits
  • Severe Intensity: Withdrawal of 20% of stable individual deposits

• Withdrawal of a portion of Non-Stable Individual Deposits:

  • Moderate Intensity: Withdrawal of 10% of non-stable individual deposits
  • Medium Intensity: Withdrawal of 20% of non-stable individual deposits
  • Severe Intensity: Withdrawal of 40% of non-stable individual deposits

• Withdrawal of a portion of Stable Corporate Deposits:

  • Moderate Intensity: Withdrawal of 5% of stable corporate deposits
  • Medium Intensity: Withdrawal of 10% of stable corporate deposits
  • Severe Intensity: Withdrawal of 20% of stable corporate deposits

4. Regarding liquidity risk, when applying Basel III guidelines, the tests specific to the Liquidity Coverage Ratio (LCR) can be expanded.
5. The bank can refer to the Basel III standard regarding the determination of stable deposits, with the necessity of providing the Central Bank with details of the method used by the bank to determine these deposits.

• Withdrawal of a portion of Non-Stable Corporate Deposits:

  • Moderate Intensity: Withdrawal of 10% of non-stable corporate deposits
  • Medium Intensity: Withdrawal of 20% of non-stable corporate deposits
  • Severe Intensity: Withdrawal of 40% of non-stable corporate deposits

• Withdrawal of a portion of Unused Limits from Facilities for Individuals and SMEs:

  • Moderate Intensity: Withdrawal of 5% of unused limits from facilities for individuals and SMEs
  • Medium Intensity: Withdrawal of 10% of unused limits from facilities for individuals and SMEs
  • Severe Intensity: Withdrawal of 20% of unused limits from facilities for individuals and SMEs

• Withdrawal of a portion of Unused Limits from Facilities for Non-Financial Companies:

  • Moderate Intensity: Withdrawal of 10% of unused limits from facilities for non-financial companies
  • Medium Intensity: Withdrawal of 20% of unused limits from facilities for non-financial companies
  • Severe Intensity: Withdrawal of 40% of unused limits from facilities for non-financial companies

• Withdrawal of a portion of Unused Limits from Facilities for Financial Companies:

  • Moderate Intensity: Withdrawal of 40% of unused limits from facilities for financial companies
  • Medium Intensity: Withdrawal of 80% of unused limits from facilities for financial companies
  • Severe Intensity: Withdrawal of 100% of unused limits from facilities for financial companies

• Withdrawal of the Largest Deposits:

  • Moderate Intensity: Withdrawal of the largest deposit
  • Medium Intensity: Withdrawal of the three largest deposits
  • Severe Intensity: Withdrawal of the five largest deposits

• Decrease in Liquid Assets:

  • Moderate Intensity: Decrease in liquid assets at the bank by 10%
  • Medium Intensity: Decrease in liquid assets at the bank by 20%
  • Severe Intensity: Decrease in liquid assets at the bank by 40%

D. Operational Risk For operational risk tests, the bank must assume three minimum scenarios to measure the potential impact on the bank's profitability and regulatory capital adequacy ratio. These include:

• Occurrence of internal fraud or system burnout.
• Impact on the bank's reputation due to changes in banking behavior or regulatory actions.
• Imposition of penalties by the supervisory authority in the host or home country.
• Significant violation by the bank of any laws, regulations, or codes of conduct.
• Other unsafe or unsound banking practices.

E. Additional Stress Tests In addition to the specified tests above, the bank is required to conduct additional tests, with no less than one additional test for each type of risk it faces, proportional to the size and nature of the risks it faces.

Second: Scenario Tests

The macro scenarios are designed to assess the bank's ability to withstand shocks, assuming a worsening of regional conditions surrounding the Kingdom, significantly affecting Jordan due to the return of workers and a noticeable decline in the volume of aid from Gulf countries. This leads to a noticeable slowdown in growth rates, a decrease in tourism income and direct investment, and an increase in interest rates. It is also assumed that the Central Bank of Jordan continues to raise interest rates at a faster pace than expected to maintain the Dinar's attractiveness as a currency against the US Dollar, negatively affecting the economy of the Kingdom.

The impact of these assumptions on banks is usually measured using the Economic Growth Rate (as one of the main economic variables affecting non-performing loans). This impact is measured on the regulatory capital adequacy ratio to basic capital. Economic research indicates that a decrease in the economic growth rate leads to an increase in non-performing loans, thereby reducing customers' ability to repay their debts due to the decline in economic activity. Other variables such as interest rates, unemployment rate, and inflation rate can also be used to predict the percentage of non-performing loans. A Multiple Regression Analysis methodology is used to predict the percentage of non-performing loans for the coming year according to the following model:

NPL = ß0 + ß1NPL(-1) + ß2X1 + ß3X2 + … + ßn+1Xn + e

Where:

• NPL: Percentage of non-performing loans for the coming year
• ß0: Constant
• NPL(-1): Percentage of non-performing loans for the previous year
• X1-Xn: Macroeconomic variables used to predict non-performing loans (e.g., economic growth rate, interest rates, unemployment rate, equity prices, etc.)
• ß1-ßn: Regression Coefficients

The Central Bank specifically requires banks to conduct the following scenarios. Note that the required scenarios may vary from year to year.

A. Baseline Scenario (Current Situation): The macroeconomic variables are based on the International Monetary Fund's forecasts, as shown in Appendix No. (3).

B. Medium Macro Stress Scenario:

• Economic growth rate in the Kingdom decreases to 0.3%
• Unemployment rate increases to 19.9%
• Interest rates increase by 100 basis points

C. Severe Macro Stress Scenario:

• Economic growth rate in the Kingdom decreases to -1.9%
• Unemployment rate increases to 21.4%
• Interest rates increase by 200 basis points

Note that the following methodology was used to reach the above ratios:

• Medium Macro Stress Scenario: The expected economic growth rate for 2018 is reduced by one standard deviation of the economic growth rate data during the period (1994-2017), and the unemployment rate for 2017 is added to one standard deviation of the unemployment rate data during the period (1994-2017).
• Severe Macro Stress Scenario: The expected economic growth rate for 2018 is reduced by two standard deviations of the economic growth rate data during the period (1994-2017), and the unemployment rate for 2017 is added to two standard deviations of the unemployment rate data during the period (1994-2017).

Regarding the assumptions used for interest rates, they were derived in accordance with the guidelines of Instruction No. (2016/1) on Stress Testing for Banks in Jordan, dated 2016/12/6, regarding the standard shock for interest rate risk.

3. Basel III Standard.
4. Basel III Standard.
5. Basel III Standard.
6. Basel III Standard.
7. Basel III Standard.

3 According to the Capital Adequacy Instructions under Basel III.

2 According to the Capital Adequacy Instructions under Basel III.

3 Repricing risk is one of the most prominent interest rate risks, resulting from differences in maturity dates (fixed interest rates) or repricing dates (variable interest rates). For example, if the bank finances long-term fixed-interest loans using short-term variable-interest deposits, the bank will face a decline in future income if interest rates rise. This decline is due to the cash flows from the long-term fixed loan being higher than the interest paid on the deposit. The test begins by determining a schedule for distributing interest-rate-sensitive assets and liabilities (variable interest rates) and maturity dates (fixed interest rates) according to time periods, thereby determining the impact of interest rate decreases on the bank's profits and value.

4 Regarding liquidity risk, when applying Basel III guidelines, the tests specific to the Liquidity Coverage Ratio (LCR) can be expanded. 5. The bank can refer to the Basel III standard regarding the determination of stable deposits, with the necessity of providing the Central Bank with details of the method used by the bank to determine these deposits.

6. According to the Capital Adequacy Instructions under Basel III.
7. According to the Capital Adequacy Instructions under Basel III.

Appendix No. (1): Sensitivity Analysis Tests Forms

Credit Risk

Shock Intensity	Before Shock	After Shock
Regulatory Capital Adequacy Ratio	Basic Capital	Risk-Weighted Assets
Increase in Non-Performing Loans by 50% (Moderate)
Increase in Non-Performing Loans by 100% (Medium)
Increase in Non-Performing Loans by 150% (Severe)
Increase in Non-Performing Loans for the Five Largest Economic Sectors Holding Direct Facilities from the Bank by 10% (Moderate)
Increase in Non-Performing Loans for the Five Largest Economic Sectors Holding Direct Facilities from the Bank by 25% (Medium)
Increase in Non-Performing Loans for the Five Largest Economic Sectors Holding Direct Facilities from the Bank by 50% (Severe)
Increase in Non-Performing Loans Granted to the Real Estate Sector by 10% (Moderate)
Increase in Non-Performing Loans Granted to the Real Estate Sector by 25% (Medium)
Increase in Non-Performing Loans Granted to the Real Estate Sector by 50% (Severe)
Default of the Largest Borrowers (Excluding Facilities Guaranteed by the Jordanian Government and classified as credit to them) - 1 (Moderate)
Default of the Largest Borrowers (Excluding Facilities Guaranteed by the Jordanian Government and classified as credit to them) - 3 (Medium)
Default of the Largest Borrowers (Excluding Facilities Guaranteed by the Jordanian Government and classified as credit to them) - 6 (Severe)
Decrease in the Value of Collateral Placed Against Non-Performing Loans by 10% (Moderate)
Decrease in the Value of Collateral Placed Against Non-Performing Loans by 20% (Medium)
Decrease in the Value of Collateral Placed Against Non-Performing Loans by 30% (Severe)

Market Risk

Shock Intensity	Before Shock	After Shock
Profit/Loss	Capital Adequacy Ratio	Basic Capital
Decrease in Exchange Rate of the Jordanian Dinar by 15% (Moderate)
Decrease in Exchange Rate of the Jordanian Dinar by 20% (Medium)
Decrease in Exchange Rate of the Jordanian Dinar by 25% (Severe)
Increase in Exchange Rate of the Jordanian Dinar by 15% (Moderate)
Increase in Exchange Rate of the Jordanian Dinar by 20% (Medium)
Increase in Exchange Rate of the Jordanian Dinar by 25% (Severe)
Decrease/Increase in Interest Rates by 100 Basis Points (Moderate)
Decrease/Increase in Interest Rates by 150 Basis Points (Medium)
Decrease/Increase in Interest Rates by 200 Basis Points (Severe)
Decrease in Equity Prices by 10% (Moderate)
Decrease in Equity Prices by 20% (Medium)
Decrease in Equity Prices by 30% (Severe)

Liquidity Risk

Shock Intensity	Before Shock	After Shock
Legal Liquidity Ratio	Legal Liquidity Ratio	Legal Liquidity Ratio
Withdrawal of a portion of Stable Individual Deposits by 5% (Moderate)
Withdrawal of a portion of Stable Individual Deposits by 10% (Medium)
Withdrawal of a portion of Stable Individual Deposits by 20% (Severe)
Withdrawal of a portion of Stable Corporate Deposits by 5% (Moderate)
Withdrawal of a portion of Stable Corporate Deposits by 10% (Medium)
Withdrawal of a portion of Stable Corporate Deposits by 20% (Severe)
Withdrawal of a portion of Unused Limits from Facilities for Financial Companies by 40% (Moderate)
Withdrawal of a portion of Unused Limits from Facilities for Financial Companies by 80% (Medium)
Withdrawal of a portion of Unused Limits from Facilities for Financial Companies by 100% (Severe)
Withdrawal of a portion of Non-Stable Individual Deposits by 10% (Moderate)
Withdrawal of a portion of Non-Stable Individual Deposits by 20% (Medium)
Withdrawal of a portion of Non-Stable Individual Deposits by 40% (Severe)
Withdrawal of a portion of Non-Stable Corporate Deposits by 10% (Moderate)
Withdrawal of a portion of Non-Stable Corporate Deposits by 20% (Medium)
Withdrawal of a portion of Non-Stable Corporate Deposits by 40% (Severe)
Withdrawal of a portion of Unused Limits from Facilities for Individuals and SMEs by 5% (Moderate)
Withdrawal of a portion of Unused Limits from Facilities for Individuals and SMEs by 10% (Medium)
Withdrawal of a portion of Unused Limits from Facilities for Individuals and SMEs by 20% (Severe)
Withdrawal of a portion of Unused Limits from Facilities for Non-Financial Companies by 10% (Moderate)
Withdrawal of a portion of Unused Limits from Facilities for Non-Financial Companies by 20% (Medium)
Withdrawal of a portion of Unused Limits from Facilities for Non-Financial Companies by 40% (Severe)
Withdrawal of the Largest Deposit (Moderate)
Withdrawal of the Three Largest Deposits (Medium)
Withdrawal of the Five Largest Deposits (Severe)
Decrease in Liquid Assets by 10% (Moderate)
Decrease in Liquid Assets by 20% (Medium)
Decrease in Liquid Assets by 40% (Severe)

Appendix No. (2): Scenario Tests Form

Shock Intensity	Before Shock	After Shock
Regulatory Capital Adequacy Ratio	Basic Capital	Risk-Weighted Assets
Medium Macro Scenario
Economic Growth Rate	0.3%
Unemployment Rate	19.9%
Interest Rate Increase	100 Basis Points
Severe Macro Scenario
Economic Growth Rate	-1.9%
Unemployment Rate	21.4%
Interest Rate Increase	200 Basis Points

Appendix No. (3): Macroeconomic Variables

Year	Real Economic Growth Rate	Unemployment Rate	Weighted Average Interest Rate on Loans (Credit Facilities)	Inflation Rate
1994	3.60	10.4	15.80	4.98
1995	2.20	10.7	15.40	6.19
1996	6.60	11.6	13.10	2.08
1997	3.00	12.6	14.40	3.32
1998	3.10	12.9	13.50	3.01
1999	0.60	12.7	14.38	3.38
2000	0.70	11.4	13.71	4.25
2001	1.70	10.5	14.69	5.27
2002	1.90	9.9	15.33	5.79
2003	2.40	8.9	14.44	4.18
2004	2.60	7.6	14.70	8.56
2005	3.50	8.1	14.80	8.14
2006	6.30	8.6	14.00	8.09
2007	4.70	8.9	13.10	8.18
2008	13.90	9.5	12.70	7.23
2009	-0.70	9.1	12.90	5.48
2010	5.10	9.0	12.50	2.31
2011	4.40	8.7	12.90	2.59
2012	4.60	9.0	12.20	2.65
2013	5.60	9.0	12.60	2.80
2014	2.90	8.8	11.90	3.10
2015	-0.90	8.2	13.00	2.50
2016	-0.80	7.8	15.30	2.00
2017	3.3	8.6	*18.5	*1.90
2018	**1.5	**2.5

• As of 2017/9/30, according to IMF estimates. ** According to IMF estimates.