Circular on Stress Testing Requirements for Banks in Jordan Based on 2017 Year-End Data

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

With best regards,

Following the instructions for Stress Testing Requirements for Banks in Jordan Based on 2017 Year-End Data (No. 2016/1), dated 2016/12/06, attached are the required scenarios for sensitivity analysis tests. Banks are required to conduct these tests based on data as of 2017/12/31, at the level of consolidated financial statements and, for branches of banks operating in Jordan, at the branch level. Banks are requested to send us the results of the required tests only at the branch level for banks operating in Jordan. The attached forms should be filled out and submitted to the Central Bank annually, taking into account developments in risks, with the deadline being the end of March 2018.

With highest respect and acceptance,

Governor Dr. Ziad Al-Fraiz

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Stress Testing Requirements for Banks Based on 2017 Year-End Data

First: Sensitivity Analysis Tests

A. Credit Risk

These tests aim to measure the effect of the economic cycle, in addition to bank-specific factors, on the increase in credit risk at the bank, and consequently on the bank's profitability and the ratio of regulatory capital to risk-weighted assets 1.

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%

1 According to Basel III Standard for Regulatory Capital Instructions.

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

Non-factor:

• 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 consequently on the ratio of regulatory capital to risk-weighted assets 2.

1. First Shock: Exchange Rate Risk

• Decrease in the Exchange Rate of the Dinar: Assumed Decrease:

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

• Increase in the Exchange Rate of the Dinar: Assumed Increase:

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

2 According to Basel III Standard for Regulatory Capital Instructions.

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2. Second Shock: Interest Rate Risk

Changes in interest rates in the market may negatively affect the bank's financial position, in addition to the direct impact on the bank's net interest income (bank revenues), and the impact on the market value of the bank's assets and liabilities from the medium to long term at a rate equal to their value.

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

Gap Analysis Tests:

These tests aim to determine the bank's position regarding:

Assumed Decrease/Increase:

• Moderate Intensity: 100 basis points decrease/increase in interest rates
• Medium Intensity: 150 basis points decrease/increase in interest rates
• Severe Intensity: 200 basis points decrease/increase in interest rates

3. Third Shock: Share Price Decrease Risk

Assumed Decrease:

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

3 Repricing risk is one of the most prominent interest rate risks resulting from differences in maturity dates (fixed interest rates) and interest rate sensitivity (variable interest rates). For example, if the bank finances long-term fixed interest rate loans using short-term variable interest rate deposits, the bank will face a decrease in its future income if interest rates rise. The decrease 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 the distribution of assets and liabilities off-balance sheet sensitive to interest rates (variable interest rates) and maturity dates (fixed interest rates), then determining the impact on the bank's profits and value due to interest rate decreases according to time periods.

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C. Liquidity Risk 4:

The liquidity risk at the bank depends significantly on the bank's ability to meet its obligations. In addition, the bank must conduct expectations of cash inflows and outflows to determine cash requirements under normal operating conditions. During the implementation of "What if" scenarios for cash flow expectations under stress conditions, the bank is required to conduct the following tests, specifically to measure the impact on the bank's liquidity:

1. Outflows Tests:

• Withdrawal of a portion of Stable Individual Deposits: Assumed Decrease:

  • Moderate Intensity: 5% withdrawal of a portion of stable individual deposits
  • Medium Intensity: 10% withdrawal of a portion of stable individual deposits
  • Severe Intensity: 20% withdrawal of a portion of stable individual deposits

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

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

• Withdrawal of a portion of Stable Corporate Deposits: Assumed Decrease:

  • Moderate Intensity: 5% withdrawal of a portion of stable corporate deposits
  • Medium Intensity: 10% withdrawal of a portion of stable corporate deposits
  • Severe Intensity: 20% withdrawal of a portion of stable corporate deposits

4 Regarding liquidity risk, tests can be expanded when applying Basel III regarding the Liquidity Coverage Ratio (LCR).

5 The bank can refer to Basel III standard or use the bank's specific methodology to determine stable deposits, with details of the method used by the bank to determine these deposits.

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

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

• Withdrawal of a portion of Unutilized Limits from Facilities for Individuals and Small and Medium Enterprises: Assumed Decrease:

  • Moderate Intensity: 5% withdrawal of a portion of unutilized limits from facilities for individuals and small and medium enterprises
  • Medium Intensity: 10% withdrawal of a portion of unutilized limits from facilities for individuals and small and medium enterprises
  • Severe Intensity: 20% withdrawal of a portion of unutilized limits from facilities for individuals and small and medium enterprises

• Withdrawal of a portion of Unutilized Limits from Facilities for Non-Financial Companies: Assumed Decrease:

  • Moderate Intensity: 10% withdrawal of a portion of unutilized limits from facilities for non-financial companies
  • Medium Intensity: 20% withdrawal of a portion of unutilized limits from facilities for non-financial companies
  • Severe Intensity: 40% withdrawal of a portion of unutilized limits from facilities for non-financial companies

• Withdrawal of a portion of Unutilized Limits from Facilities for Financial Companies: Assumed Decrease:

  • Moderate Intensity: 40% withdrawal of a portion of unutilized limits from facilities for financial companies
  • Medium Intensity: 80% withdrawal of a portion of unutilized limits from facilities for financial companies
  • Severe Intensity: 100% withdrawal of a portion of unutilized limits from facilities for financial companies

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• Withdrawal of the Largest Deposits: Assumed Decrease:

  • 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: Assumed Decrease:

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

D. Operational Risk 6:

For operational risk tests, the bank must assume three minimum assumptions to measure the potential impact on the bank's profitability and the ratio of regulatory capital to risk-weighted assets 6:

• Occurrence of internal fraud, such as a fire in the bank's infrastructure or some bank losses.
• Change in bank behavior or supervisory action, affecting the bank's reputation.
• Imposition of a penalty on the bank by the supervisory authority in the host or home country, due to the bank's serious violation of any laws, regulations, or practices, etc., that are not safe or sound banking practices.

E. Additional Stress Tests:

In addition to the tests specified above, the bank is required to conduct additional tests, not 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 Gulf crisis, leading to a noticeable decline in the form of workers' remittances, in addition to a decrease in the volume of aid from Gulf countries. This may lead to a noticeable slowdown in growth rates, a decrease in tourism income and direct investment, and an increase in interest rates. Also, assuming the Jordanian Central Bank continues to raise interest rates at a faster pace than expected to maintain the attractiveness of the Dinar as a currency, which may negatively affect economic growth in the Kingdom.

6 According to Basel III Standard for Regulatory Capital Instructions.

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The rate of economic growth (GDP growth rate) is usually used to measure the impact of these assumptions on banks (as one of the main economic variables affecting non-performing facilities). This impact is measured on the ratio of regulatory capital to risk-weighted assets 7.

7 According to Basel III Standard for Regulatory Capital Instructions.

Economic research indicates that a decrease in the economic growth rate leads to an increase in non-performing facilities, and consequently a decline in customers' ability to repay their debts due to the decline in economic activity. Other variables such as the inflation rate, unemployment rate, and interest rates can also be used to predict the percentage of non-performing facilities for the coming year.

The Multiple Regression Analysis methodology is used to predict the percentage of non-performing facilities for the coming year according to the following model:

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

Where:

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

The Central Bank will specifically require banks to conduct the following scenarios, noting that the required scenarios may differ from banks to banks on an annual basis.

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A. Baseline Scenario (Current Situation):

The macroeconomic variables are based on the International Monetary Fund's forecasts, as shown in Appendix (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 subtracted by one standard deviation of the economic growth rate data during the period (1994-2017), and one standard deviation of the unemployment rate data during the period (1994-2017) is added to the 2017 unemployment rate.

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

As for the assumptions used for interest rates, they were derived in accordance with the instructions for Stress Testing Requirements for Banks in Jordan Based on 2017 Year-End Data (No. 2016/1), dated 2016/12/6, regarding the standard shock for interest rate risk and Basel Committee guidelines.

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Appendix (1): Sensitivity Analysis Tests Forms

Credit Risk

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

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Market Risk

Shock Intensity	Before Shock	After Shock
Regulatory Capital Adequacy Ratio	Risk-Weighted Assets	Profit/Loss
Basic Capital	Basic Capital
Decrease in Exchange Rate of the Dinar by 15% (Moderate)
Decrease in Exchange Rate of the Dinar by 20% (Moderate)
Decrease in Exchange Rate of the Dinar by 25% (Severe)
Increase in Exchange Rate of the Dinar by 15% (Moderate)
Increase in Exchange Rate of the Dinar by 20% (Moderate)
Increase in Exchange Rate of the Dinar by 25% (Severe)
Interest Rate Gap Analysis: Decrease/Increase in Interest Rates by 100 Basis Points (Moderate)
Interest Rate Gap Analysis: Decrease/Increase in Interest Rates by 150 Basis Points (Medium)
Interest Rate Gap Analysis: Decrease/Increase in Interest Rates by 200 Basis Points (Severe)
Share Price Decrease Risk: 10% Decrease (Moderate)
Share Price Decrease Risk: 20% Decrease (Medium)
Share Price Decrease Risk: 30% Decrease (Severe)

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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	Withdrawal of a portion of Stable Non-Individual Deposits	Withdrawal of a portion of Unutilized Limits from Facilities for Financial Companies
5% (Moderate)	5% (Moderate)	40% (Moderate)
10% (Medium)	10% (Medium)	80% (Medium)
20% (Severe)	20% (Severe)	100% (Severe)
Withdrawal of a portion of Stable Non-Corporate Deposits	Withdrawal of a portion of Unutilized Limits from Facilities for Non-Financial Companies	Withdrawal of a portion of Unutilized Limits from Facilities for Individuals and Small and Medium Enterprises
10% (Moderate)	10% (Moderate)	1% (Moderate)
20% (Medium)	20% (Medium)	3% (Medium)
40% (Severe)	40% (Severe)	5% (Severe)
Withdrawal of the Largest Deposits	Decrease in Liquid Assets
10% (Moderate)	10% (Moderate)
20% (Medium)	20% (Medium)
40% (Severe)	40% (Severe)

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Appendix (2): Scenario Tests Model

Shock Intensity	Before Shock	After Shock
Regulatory Capital Adequacy Ratio	Risk-Weighted Assets	Non-Performing Loans Provisions
Basic Capital	Basic Capital
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

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Appendix (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 International Monetary Fund estimates. ** According to International Monetary Fund estimates.