Bangko Sentral ng Pilipinas (BSP) Governor Eli M. Remolona Jr. said they are fine-tuning and improving an early warning signal (EWS) system that is capable of predicting an oncoming financial crisis that could hit the Philippines in the future.

One of these work-in-progress EWS is the economic volatility index (EVI) that BSP has been perfecting for the past year.

“We’re working on these indices. We want an early warning signal for stress,” said Remolona. “We want an index that’s calibrated so that it actually predicts (a crisis).”

Besides the crucial development of the EVI, the BSP’s Department of Economic Research is also transitioning to the Policy Analysis Model for the Philippines (PAMPh), in cooperation with the International Monetary Fund’s (IMF) Institute for Capacity Development (IMF-ICD) and the Japan International Cooperation Agency.

Remolona said that besides developing indices such as the EVI, they are also updating and making more critical the PAMPh.

PAMPh allows the BSP to present a more detailed outlook of inflation and growth, as an enhanced workhorse model. The new model will be extensively tested before it is used publicly.

Currently, the BSP forecasts inflation using the Multi-Equation Model (MEM) but an improved PAMPh will complement MEM

According to Remolona, “the indices were put together as far as I know … by collecting different variables that might be related to stress or may not be related, and then we took averages.”

The BSP chief, who has worked for the Bank for International Settlements (BIS) handling banking system problems, said the BSP continues to review and study events correlated with the 2008 and 2009 global financial crisis.

“We need to do what I call narrative identification. It’s not enough to have an index that’s based on averages. We have to somehow calibrate them so that they actually predict the crisis, especially our own crisis,” said Remolona.

The data-dependent, inflation-targeting BSP has been improving its statistics using technology and the most advanced analytics for a more accurate data and forecasting methods.

The BSP is an active member of the country’s statistical system which makes it “a producer of economic and financial data.”

“We underscore the importance of accurate, timely, and relevant statistics. These are essential in fostering our economy’s growth and our resilience against shocks,” said Remolona last October.

The BSP prides itself as having a credible and accurate forecasting methods. It has noted always that its ability to forecast inflation is more than adequate, and that its forecasting performance are generally “accurate, unbiased and efficient” during the last 12 years, and even outperforming forecasts from the private sector.

To improve its forecasting performance, the BSP since last year has intensified efforts to acquire real-time information for it to identify emerging risks across different sectors.

They developed and continue to develop new tools such as machine learning methods to analyze non-traditional data such as internet searches, newspaper articles, and social media posts.

BSP improves stress test exercises

As it refines and develop more effective indices and forecasting methods, the BSP is also strengthening its stress testing exercises by adopting the reverse stress tests to improve its surveillance mechanisms and forward-looking indicators in scrutinizing a bank’s asset health.

In a report, the BSP said it now implements the Reverse Stress Test framework which it said “offers a simple, balance sheet-based tool to assess the ability of banks to withstand credit shocks.”

The reverse stress tests involve comparing banks’ non-performing loan (NPL) ratios and the “breakeven NPL ratios” to allow the BSP to “identify the most vulnerable to a credit shock.” NPLs refer to loan accounts whose principal or interest is unpaid for thirty days or more after due date or after they have become past due. As for NPL ratio, it is the percentage of NPLs to total loans, gross of allowance for credit losses but inclusive of interbank loans.

The BSP said the banking system's vulnerability to a crisis can be estimated by defining the so-called “banks at risk." This is done by selecting the most vulnerable banks with cumulative assets of at least 20 percent of the total asset base of universal and commercial banks or the big banks to indicate potential vulnerability due to credit shock.

Meanwhile, the framework is also enhanced by other forward-looking asset quality indicators used by the BSP such as the loans-at-risk and distressed loans by “incorporating information on loans with missed payments and restructured loans while allowing a straightforward assessment of banks’ vulnerability to credit shocks,” explained the BSP.

BSP describes stress testing as the assessment of a bank’s potential losses and capital reduction under a set of scenarios based on macroeconomic projections. “In contrast, reverse stress testing involves a focused assessment that measures how much a bank's existing condition must change for a predetermined adverse outcome,” it noted.