Stress Testing ;
Globally, banks are increasingly relying on statistical models to measure and manage the financial risks to which they are exposed. These models are gaining credibility because they provide a framework for identifying, analysing, measuring, communicating and managing these risks. Since models cannot incorporate all possible risk outcomes and are generally not capable of capturing sudden and dramatic changes, banks supplement models with ‘stress tests’. Internationally, stress testing has become an integral part of banks’ risk management systems and is used to evaluate the potential vulnerability to some unlikely but plausible events or movements in financial variables. There are broadly two categories of stress tests used in banks, viz., sensitivity tests and scenario tests. These may be used either separately or in conjunction with each other.
Banks usually use a wide range of quantitative tools and matrices to measure and monitor risks. Some of the commonly used tools to measure and monitor market risk are Value at Risk (VAR) and Stress Testing.
RBI, vide its circular no. DBOD. No. BP. BC.101 / 21.04.103/ 2006-07 dated June 26, 2007 on “Guidelines on Stress Testing” has required that all commercial banks (excluding RRBs and LABs) shall put in place a Board approved ‘Stress Testing framework’ to suit their individual requirements which would integrate into their risk management systems. The circular further requires that the framework should satisfy certain essential requirements as listed therein.
The circular also states that while traditionally stress tests are used in the context of managing market risks, these may also be employed in the management of credit risks, operational risks and liquidity funding risk. Banks should identify their major risks that should be subjected to stress tests.
Banks should stress the relevant parameters at least at three levels of increasing adversity – minor, medium, and major – with reference to the normal situation and estimate the financial resources needed by it under each of the circumstances to:
a) meet the risk as it arises and for mitigating the impact of manifestation of that risk;
b) meet the liabilities as they fall due; and
c) meet the minimum CRAR requirements. Banks may apply stress tests at varying frequencies dictated by their respective business requirements, relevance and cost.
The results of the various stress tests should be reviewed by the senior management and reported to the Board. The circular emphasises that these results should be an essential ingredient of bank’s risk management systems.
The remedial actions that banks may consider necessary to activate when the various stress tolerance levels are breached may include:
a) Reduction of risk limits;
b) Reduction of risks by enhancing collateral requirements, seeking higher level of risk mitigants, undertaking securitisation, and hedging;
c) Amend pricing policies to reflect enhanced risks or previously unidentified risks;
d) Augmenting the capital levels to enhance the buffer to absorb shocks;
e) Enhancing sources of funds through credit lines, managing the liability structure, altering the liquid asset profile, etc.
Stress tests should, as far as possible, be conducted on a bank-wide basis and should be adequately tailored to capture country or market or portfolio specific factors. Stress tests undertaken on a bank-wide basis enable the Board and senior management to assess the potential impact of the stress situations on the bank’s earnings and capital position, and enable them to develop or choose appropriate strategies for mitigating and managing the impact of those situations.
The framework also helps bank managements in understanding the bank’s risk profile and adjusting it in accordance with their risk appetite. The stress test results should be considered while establishing and reviewing various policies and limits.
RBI requires the banks to put in place appropriate stress test policies and the relevant stress test framework for the various risk factors by September 30, 2007 as also to ensure that their formal stress testing frameworks, which are in accordance with these guidelines, are operational from March 31, 2008.