A. Stress-Testing
Stress-testing is a generic term for the assessment of vulnerability of individual financial institutions and the financial system to internal and external shocks. Typically, it applies ‘What if’ scenarios and attempts to estimate expected losses from shocks, including capturing the impact of ‘large, but plausible events’. Stresstesting methods include scenario tests based on historical events and information on hypothetical future events. They may also include sensitivity tests. A good stress-test should have attributes of plausibility and consistency and ease of reporting for managerial decisions.
1. Stress-Testing Under Pillar 1
i. A Bank must conduct on a regular basis appropriate stress-tests so as to:
a) Identify sources of potential liquidity strain:
- Loss of confidence – justified/unjustified.
- Contagion – financial sector weakness, corporate failures, etc.
- External factors – market disruption, risk aversion, flight to quality, etc.
- Uncorrelated events – operational disruptions, natural disasters, terrorist attacks, etc.
b) Ensure that current liquidity exposures continue to conform to the liquidity risk tolerance established by that bank's governing body.
c) Identify the effects on that bank's assumptions about pricing.
d) Analyse the separate and combined impact of possible future liquidity stresses on its:
- Cash flows.
- Liquidity position.
- Profitability.
- Solvency.
ii. A bank must consider the potential impact of institution-specific, market-wide and combined alternative scenarios.
iii. In conducting its stress-testing, a bank should also, where relevant, consider the impact of its chosen stresses on the appropriateness of its assumptions relating to:
- Correlations between funding markets.
- The effectiveness of diversification across its chosen sources of funding.
- Additional margin calls and collateral requirements.
- Contingent claims, including potential draws on committed lines extended to third parties or to other entities in that bank's group.
- Liquidity absorbed by off-balance sheet activities.
- The transferability of liquidity resources.
- Access to central bank market operations and liquidity facilities.
- Estimates of future balance sheet growth.
- The continued availability of market liquidity in a number of currently highly liquid markets.
- Ability to access secured and unsecured funding (including retail deposits).
- Currency convertibility.
- Access to payment or settlement systems on which the bank relies.
iv. A Bank should ensure that the results of its stress-tests are:
- Reviewed by its senior management.
- Reported to the bank's Board of Directors or its deleted authority, specifically highlighting any vulnerabilities identified and proposing appropriate remedial action.
- Reflected in the processes, strategies and systems.
- Used to develop effective contingency funding plans.
- Integrated into that bank's business planning process and day-today risk management.
- Taken into account when setting internal limits for the management of that bank's liquidity risk exposure.
v. Among more qualitative criteria that banks would have to meet before they are permitted to use a models based approach are the followings:
- Rigorous and comprehensive stress-testing program should be in place.
- Cover a range of factors that can create extraordinary losses or gains in trading portfolios.
- Major goals of stress-testing are to evaluate the capacity of the bank’s liquidity to absorb potential large losses and to identify steps the bank can take to reduce its risk and conserve liquidity.
- Results of stress-testing should be routinely communicated to senior management and periodically, to the bank’s board of directors.
vi. Results of stress-tests should be reflected in the policies and limits set by the management.
vii. Scenarios to be employed:
- Historical without simulation.
- Historical with simulation – this means relating to specific profile and idiosyncratic nature of the bank. e.g. if deposits are highly concentrated with top three customers, if one customer goes for an early withdrawal or partial withdrawal, how this simulation would affect historical analysis?
- Adverse events, based on individual portfolio characteristics of institutions.
2. Stress-Testing Under Pillar 2
Under the Supervisory Review Process, SAMA will initially review the Pillar 1 stress-testing requirement for LCR and NSFR. SAMA will also assess stress-testing under Pillar 2 with specific reference to detailed Contingency Funding Plan (CFP). Some of the scenarios which can be used are:
i. Example of First Liquidity Stress
An unforeseen, name-specific, liquidity stress in which:
- Financial market participants and retail depositors consider that in the short-term the bank will be or is likely to be unable to meet its liabilities as they fall due.
- The bank's counterparties reduce the amount of intra-day credit which they are willing to extend to it.
- The bank ceases to have access to foreign currency spot and swap markets.
- Over the longer-term, the bank's obligations linked to its credit rating crystallize as a result of a reduction in that credit rating. For the purpose, a bank must assume that the initial, short-term, period of stress lasts for at least two weeks.
ii. Example of Second Liquidity Stress
An unforeseen, market-wide liquidity stress of three months duration. A bank must assume that the second liquidity stress is characterised by:
- Uncertainty as to the accuracy of the valuation attributed to that bank's assets and those of its counterparties.
- Inability to realise, or ability to realise only at excessive cost, particular classes of assets, including those which represent claims on other participants in the financial markets or which were originated by them.
- Uncertainty as to the ability of a significant number of banks to ensure that they can meet their liabilities as they fall due.
- Risk aversion among participants in the markets on which the bank relies for funding.
3. Other Aspects Related to Stress-Testing
i. SAMA expects all banks to closely review the above recommendations on stress-testing and develop specific strategies and methodologies to implement those that are relevant and appropriate for their operations.
ii. SAMA in its evaluation of banks method and systems under Pillar 1 and Pillar 2 will examine the implementation of these stress-test requirements. It will also review the stress-test methodologies and systems as part of its Supervisory Review Process.
iii. As a minimum, a bank should carryout stress-tests at least on an annual basis.