Macroeconomic and Financial Stability: Stress Testing of the Impacts of Macroeconomic Shocks on Credit/Asset Quality of Banking System in Kuwait based on Macro Econometric Model of Kuwait

The importance of financial sector came to the forefront with the onset of the global financial crisis in 2007-08, and it was understood that the costs are immense if the instability of the financial sector spreads to the real sector. Thus, maintaining macroeconomic stability and financial stability concurrently becomes now a major target and a challenge for policy makers. Financial policy makers, in turn, have given more emphasis on macro prudential analysis, which has focused on the ability of banks to withstand macroeconomic shocks based on stress tests. We carry out macroeconomic stress testing for Kuwaiti banking system to understand and assess the resilience and vulnerability of the banks as a whole in Kuwait. We build a macro model of Kuwait for the purpose, and then estimate a Credit Risk Satellite Model to carry out the stress testing. Simulation of macro model variables produces a range of future economic and financial variables such as GDP, PC, PI, CPI, M2, and CRD etc in the first stage. We estimate the Satellite Model that links, in the second stage of stress testing, NPL (non-performing loans as measure of credit risk) to the predicted macro model variables, thus mapping external shocks onto banks’ asset quality shocks. Finally, we make various assumptions about macro shocks in terms of domestic policy shocks as well as external shocks to generate baseline and recession scenarios to assess if deliberate introduction of adverse economic conditions produce any vulnerability or instability in the banking system in Kuwait. We conclude that scenario of mild recession will not produce any banking crisis in Kuwait, but more adverse conditions would produce just a little vulnerability, but not a financial crisis.