Financial
Stress Testing
from the
Basel ii Compliance Professionals Association
(BCPA)
Stress Testing and
Basel ii / Basel iii
According to the Bank of International
Settlements (BIS), the depth and duration of the financial crisis
has led many banks and supervisory authorities to
question whether stress testing
practices were sufficient prior to the crisis and whether
they were adequate to cope with rapidly changing circumstances.
In particular, not only was the crisis far
more severe in many respects than was indicated by banks' stress
testing results, but it was possibly compounded by
weaknesses in stress testing practices
in reaction to the unfolding events.
Even as the crisis is not over yet there are
already lessons for banks and supervisors emerging from this
episode.
Stress
testing is an important risk management tool that is used
by banks as part of their
internal risk management and, through
the Basel II capital adequacy framework, is promoted
by
supervisors.
Stress testing alerts bank management
to adverse unexpected outcomes related to a variety of risks and
provides an indication of how much capital might be needed to
absorb losses should large shocks occur.
Moreover, stress testing is a tool that
supplements other risk management approaches and measures.
It plays a
particularly important role in:
• providing forward-looking assessments of
risk;
• overcoming limitations of models and
historical data;
• supporting internal and external
communication;
• feeding into capital and liquidity
planning procedures;
• informing the setting of a banks’ risk
tolerance; and
• facilitating the development of risk
mitigation or contingency plans across a range of
stressed
conditions.
Stress
testing is especially important after long periods of benign
economic and financial
conditions, when fading memory of
negative conditions can lead to complacency and the
underpricing of risk.
It is also a key risk management tool during
periods of expansion, when innovation leads to new products that
grow rapidly and for which limited or no loss data is available.
Pillar 1
(minimum capital requirements) of the Basel II framework requires
banks using the
Internal Models Approach to determine market
risk capital to have in place a rigorous
programme of stress
testing.
Similarly, banks using the
advanced and foundation internal
ratings-based (IRB) approaches for credit risk are required
to conduct credit risk stress tests to assess the robustness of
their internal capital assessments and the capital cushions above
the regulatory minimum.
Basel II also requires that, at a minimum,
banks subject their credit portfolios in the banking book to
stress tests.
Recent analysis has concluded that
implementation of this requirement
would not have produced large loss numbers in relation to banks’
capital buffers going into the crisis or their actual loss
experience.
Further, the general stress tests banks are
required to conduct as part of Pillar 2
(supervisory review process) might have included more severe
scenarios than the ones currently used and
produced results
more in line with the actual stresses that were observed.
The Basel Committee has engaged with the
industry in examining stress testing practices
over this period
and this paper is the result of that examination.
Notwithstanding the ongoing evolution of the
crisis and future lessons that may emerge, this paper assesses
stress testing practices during the crisis.
Based on that assessment and in an effort to
improve practices, it develops sound
principles for banks and supervisors.
The principles cover the overall objectives,
governance, design and implementation of stress testing programmes
as well as issues related to stress testing of individual risks
and products.
The recommendations are aimed at
deepening and strengthening banks’ stress testing
practices and
their assessment by supervisors.
By itself, stress testing cannot
address all risk management weaknesses, but as part of a
comprehensive approach, it has a leading role to play in
strengthening bank corporate governance and the resilience of
individual banks and the financial system.
A stress test
is commonly described as the evaluation of the financial position
of a bank
under a severe but plausible scenario to assist in
decision making within the bank. The term
“stress testing” is
also used to refer not only to the mechanics of applying specific
individual
tests, but also to the wider environment within
which the tests are developed, evaluated and
used within the
decision-making process.
Banks that use the internal models approach
for meeting market risk capital requirements
must have in place a
rigorous and
comprehensive stress testing program.
Stress testing to identify events or
influences that could greatly impact banks is a key component of a
bank’s assessment of its capital position.
Banks’ stress scenarios need to cover a
range of factors that can create extraordinary
losses or gains in trading portfolios, or make the control of
risk in those portfolios very difficult.
These factors include
low-probability events in all major types
of risks, including the various components of
market, credit, and operational risks.
Stress scenarios need to
shed light on the impact of such events
on positions that display both linear and
nonlinear price characteristics (i.e. options and instruments
that have options-like characteristics).
Banks’ stress
tests should be both of a quantitative and
qualitative nature, incorporating both market risk and
liquidity aspects of market disturbances.
Quantitative criteria should identify
plausible stress scenarios to which banks could be exposed.
Qualitative criteria should emphasise
that
two
major goals of stress testing
are to evaluate
the capacity of the bank’s capital to absorb potential large losses
and to identify steps the
bank can take to reduce its risk and conserve capital.
This assessment is
integral to setting and evaluating the bank’s management strategy and
the results of stress testing should be
routinely communicated to senior management and, periodically,
to the bank’s board of directors.
Banks should combine the use of
supervisory stress scenarios
with
stress
tests
developed by banks themselves
to reflect their specific risk characteristics.
Specifically,
supervisory authorities may ask banks to provide information on stress
testing in three broad areas, which are discussed in turn below.
(i)
Supervisory scenarios requiring no simulations by the bank
Banks should have information on the largest losses experienced during
the reporting period available for supervisory review.
This loss information
could be compared to the level of capital
that results from a bank’s internal measurement system.
For example, it could
provide supervisory authorities with a picture of how many days of
peak day losses would have been covered by a given value-at-risk
estimate.
(ii) Scenarios requiring a simulation by the bank
Banks should subject their portfolios to a series of simulated stress
scenarios and provide supervisory authorities with the results.
These scenarios could
include testing the current portfolio against past periods of
significant disturbance,
for example, the 1987 equity crash, the ERM
crises of 1992 and 1993 or the fall in bond markets in the first
quarter of 1994, incorporating both the large price movements
and the sharp reduction in liquidity associated with these events.
A second type of
scenario would evaluate the
sensitivity of
the bank’s market risk exposure to changes in the assumptions about
volatilities and correlations.
Applying this test would
require an evaluation of the historical
range of variation for volatilities and correlations and evaluation of
the bank’s current positions against the extreme
values of the historical range.
Due consideration should
be given to the sharp variation that at
times has occurred in a matter of days in periods of significant
market disturbance.
The 1987 equity crash,
the suspension of the ERM, or the fall in bond markets in the first
quarter of 1994, for example, all involved correlations within risk
factors approaching the extreme values of 1 or -1 for several days at
the height of the disturbance.
(iii) Scenarios developed by the bank itself to capture the specific
characteristics of
its
portfolio.
In addition to
the scenarios prescribed by supervisory authorities above, a bank
should also develop its
own
stress tests
which it identifies as most adverse based on the characteristics of
its portfolio (e.g. problems in a key region of the world combined
with a sharp move in oil prices).
Banks should provide
supervisory authorities with a description of
the methodology used to identify and carry out the scenarios as
well as with a description of the results derived from these
scenarios.
The results should be reviewed periodically by
senior management and should be reflected in the policies and
limits set by management and the
board of
directors.
Moreover, if the testing reveals particular vulnerability to a given
set of circumstances, the
national authorities would expect the bank to
take prompt steps to manage those risks appropriately (e.g. by
hedging against that outcome or reducing the size of its exposures).
Read more:
Stress Testing and
Basel_ii_1
Stress Testing and
Basel_ii_2
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