Macro Stress Testing of the Philippines’ Top 10 UKBs: An Analysis of the Effect of Economic Distress on the Bank’s Credit Quality

Among the issues facing emerging markets is financial instability. In the wake of continuing global economic uncertainty, it is necessary to understand the level of preparedness of banks required for managing risks in the financial system by conducting a macro stress test. One of the key techniques for quantifying risks is stress testing which refers to a range of techniques used to assess the vulnerability of a financial system to “exceptional but plausible” macroeconomic shocks. With this, the goal of this paper is to answer the question “Does increased economic distress, in the context of lower bank competition, lead to lower credit quality?”.This research is undertaken in four different levels corresponding to the following objectives: (1) to review the historical influence of macroeconomic variables and bank competition on the credit quality of the Top 10 Universal and Commercial Banks (UKBs) of the Philippines individually; (2) to estimate the relationship between macroeconomic variables namely output growth, interest rates, inflation, exchange rate, and remittances; (3) to forecast the macroeconomic indicators under mild and moderate stress scenarios; and (4) to quantify the effect of economic distress on the credit quality of the Top 10 UKBs and the entire industry. The study used the non-performing loans ratio (NPL) as the empirical measure of credit quality. In terms of scope, the study primarily focuses on assessing the relationship between credit quality and the interested macroeconomic variables. It will not predict the probability of a bank failure given the stress scenarios. Given the presence of the Top 10 UKBs and the way the banks behave from the indicated macroeconomic stress scenarios, this paper was able to show that a decrease in remittances, GDP growth rate, and inflation, together with an increase in the interest rate and a level of exchange rate all contributed to forecasting an NPL ratio of 1.8% in both scenarios (below 5% forecasts of credit rating agencies & Basel III regulation) amidst the pandemic. Considering that the NPL ratio is well within the Basel III regulation of 5%, the UKB industry will continue to be stable.