2. Conducting Stress Tests
2.1. Types of Stress Tests
The nature of stress tests would depend on the objective(s) of conducting such tests. For the purposes of these Rules, the stress tests would either be conducted by the banks themselves or by SAMA, and would fall in any of the following categories:
i. Regular Stress Tests: Such stress tests would be conducted by the banks either at their own initiative as part of their risk management framework (in which case the nature and frequency of tests is determined by the banks themselves) or to meet the regulatory requirements of SAMA. Such Regular Stress Tests, to be conducted by banks on regular basis, are also called Bottom-up Stress Tests;
ii. Ad-hoc Stress Tests: Such tests may be conducted by the banks at irregular intervals to assess the resilience of their overall portfolio or exposure to a specific business area in the backdrop of adverse market developments or abrupt changes in the external operating environment. SAMA may also require banks to conduct ad-hoc tests from time to time and report the results thereof to SAMA in the prescribed manner;
iii. Reverse Stress Tests: Such tests may be conducted by the banks to identify the vulnerabilities and assess the resilience of their business plan. The nature of such tests is further elaborated under Section 5.4 of these Rules;
iv. Macro Stress Tests: Such tests may be conducted by SAMA from time to time to assess the resilience of the Saudi Banking System to withstand adverse shocks. These tests are also called TopDown stress tests;
2.2. Stress Testing a Mandatory Requirement
Stress Testing would henceforth be a mandatory regulatory requirement for all locally incorporated banks and those branches of foreign banks having total assets of more than 0.5% of total assets of the Saudi Banking system.. In order to meet this requirement, banks are required to conduct stress tests on regular basis. For this purpose, they should design, develop and implement their own stress testing programs in line with the nature, size and complexity of their businesses and risk profiles. The stress testing framework to be developed for this purpose should, inter alia, provide for the following:
i. State objective(s) of the stress testing exercise;
ii. Types of stress tests to be conducted;
iii. Frequency of conducting stress tests;
iv. Methodologies and techniques to be used including the defined scenarios and assumptions;
v. Broad format for compiling the results of stress tests;
vi. Strategy to deal with potential risks highlighted by the stress testing exercise;
vii. Process for monitoring implementation of the remedial action plan.
2.3. Stress Testing Parameters
The banks shall observe the following parameters in the context of doing stress testing:
i. Stress tests should be designed in such a way that banks should be able to identify potential risks in their portfolios by application of exceptional but plausible shocks;
ii. Stress tests should not be treated as substitutes of statistical models rather they complement them in identification and measurement of business risks. Thus the use of statistical models such as value-at-risk models may be continued to predict the maximum loss in normal business conditions;
iii. The stress testing methodology should be comprehensive enough to cover all material risks faced by the bank. It should also provide flexibility to capture new risks emanating from diversification in business activities and changing operating environment;
iv. The use of stress testing is also encouraged for assessing risks in portfolios that lack historical data. The lack of sufficient data may hinder the development of statistical models for such portfolios or the insufficient information / data may compromise the robustness of such models even if developed. Thus the stress testing of such portfolios may provide useful information to the management;
v. Stress tests should enable the bank to better understand its risk profile, evaluate major risks (both internal and external) and take proactive measures to mitigate those risks. They should also enable the bank to assess the adequacy of its capital;
2.4. Frequency of Stress Tests
The frequency of stress testing would generally depend on the nature and composition of the bank’s portfolio and the risks associated therewith. It would also depend on the nature of stress tests being conducted. The frequency of Regular or Ad-hoc stress tests conducted by banks at their own initiative may be determined by them in line with their stress testing frameworks and the objective(s) of conducting such tests. However, banks should take into account the latest market developments and their risk profiles in determining the frequency of such stress tests. The market sensitive portfolios e.g. equity investments and other marketable securities, foreign exchange exposures, etc. should be stressed more frequently as against the non-trading portfolios e.g. credit exposures which may be stressed at relatively longer intervals.
The frequency of stress tests to be conducted by banks to meet the requirements of SAMA under these Rules would be as under:
i. Banks shall conduct stress testing of their portfolio on regular basis at the end of every calendar half-year and report the results thereof to SAMA in the specified manner as required under these Rules;
ii. Banks shall conduct Ad-hoc stress tests for regulatory purposes on specific business areas or the overall portfolio on such frequency and within such timeline as may be specified by SAMA from time to time.