So the message has to be not one like "we think it’s too risky to extend more credit to this sector” but instead more like “have you thought about the entire range of relevant risks in extending more credit and are your underwriting criteria in line with the riskier environment?" It’s important in publishing a financial stability report to present its findings as a range of possible outcomes which the private sector can then be encouraged to factor into its own risk management practices. Stress tests and scenario analysis provide the intellectual backbone for financial stability reports. Stress testing, in particular, has come a long way in recent years. The HKMA’s requirements on stress testing by banks have been in place for some time. Our Supervisory Policy Manual Module on Stress Testing, issued in early 2003, requires banks to have in place a stress-testing programme and to integrate stress testing into their risk management processes. For our own internal purposes we also conduct stress tests by applying a range of shocks to the supervisory data that is reported to us. These shocks take into account various adverse movements in banks’ liquidity, interest rate and market risk positions. However, the techniques of stress testing are rapidly evolving and are becoming increasingly more sophisticated. The first generation of stress tests simply took a variable and subjected it to a shock. It was basically just a matter of saying "let’s see what happens to capital if NPL’s go to 20 percent."
As long as the banking system was – or at least appeared to be – sound, as central bankers we did not need to worry too much about what happened elsewhere in the financial system or the condition of the corporate sector or the structure of household balance sheets. But this is no longer true, if it ever was. I have already mentioned the role of the corporate sector in the Asian financial crises of a decade ago. The fact that it was the corporate sector rather than the banking sector that had assumed foreign exchange risk ultimately didn’t matter from the point of financial system stability. The effects were the same – or possibly were greater as the corporate sector was less well able to handle the risks than the banking sector might have been. From a macro prudential policy perspective this means that we must pay attention to conditions in the corporate sector and the soundness of corporate balance sheets. And given that so many banks in Asia have followed those in the rest of the world in looking to develop their consumer credit business, the condition of household finances is also important to understand from a financial system stability perspective. In addition, the experience of the last decade has also taught us that non-bank financial intermediaries matter for the soundness of financial systems. For example, there is plenty of evidence that insurance companies have been major sellers of credit derivatives. This passes credit risk from the banking system to the insurance sector.