Sensitivity Analysis measures the change in the value of portfolio for shocks of various degrees to a single risk factor or a small number of closely related risk factors while the underlying relationships among the risk factors are not evaluated For example, the shock might be a parallel shift in the yield curve. In sensitivity analysis, the impact of the shock on the dependent variable i.e. capital is generally estimated.

Scenario Analysis measures the change in value of portfolio due to simultaneous moves in a number of risk factors. Scenarios can be designed to encompass both movements in a group of risk factors and the changes in the underlying relationships between these variables (for example correlations and volatilities). Banks may use either the historical scenarios (a backward looking approach) or the hypothetical scenarios (a forward-looking approach) as part of their stress testing frameworks. However, they should be aware of the limitations of each of these scenarios. For example, the historical scenario may become less relevant over time due to the rapid changes in market conditions and external operating environment. On the other hand, the hypothetical scenario may be more relevant and flexible but involves more judgment and may not be backed by empirical evidence.

Banks may also use financial models in analyzing the relationships between different risk factors. However, they should exercise due care in selection of the financial or statistical models. The choice of model should take into account, inter alia, the availability of data, nature and composition of the bank’s portfolio, and its risk profile.

Reverse stress testing is used to identify and assess the stress scenarios most likely to cause a bank’s current business plan to become unviable. A reverse stress test starts with a specified outcome that challenges the viability of the bank. The analysis would then work backward (reverse engineered) to identify a scenario or combination of scenarios that could bring about such a specified outcome. The ultimate objective of reverse stress testing is to enable the banks to fully explore the vulnerabilities of their current business plan, take decisions that better integrate business and capital planning, and improve their contingency planning.

Banks are required to reverse stress test their business plan to failure i.e. the point at which the bank becomes unable to carry out its business activities due to the lack of market confidence. While doing this, they must identify a range of adverse circumstances which would cause their business plan to become unviable and assess the likelihood that such events could crystallize. In case the reverse stress testing reveal a risk of business failure that is inconsistent with the bank’s risk appetite or tolerance, it must take effective remedial measures to prevent or mitigate that risk. Banks should also document the entire process of reverse stress testing as a part of their stress testing framework.