6. Selection of Scenarios
Banks should use a range of scenarios for stress testing. The level and severity of scenarios may be varied to identify potential risks and their interactions. The decision of scenarios selection should be taken carefully after taking into account all the relevant factors. In this regard, the following broad parameters are being laid down to ensure consistency in stress testing practices across the banking industry:
6.1. Identification of Risk Factors
As part of their stress testing process, banks should identify the potential risk factors that have implications for their business activities and can adversely affect the quality of their portfolios. After careful analysis and studying the inter-relationship of various risks to which their business is exposed to, banks are expected to draw a list of the major risk factors that need to be stressed. Few examples of the risk factors are listed below:
i. Macro-economic factors such as changes in oil price, GDP growth, inflation rate, etc. which may adversely affect the bank’s business and the quality of its portfolio;
ii. Concentration risk which may be due to the concentration of a bank’s exposure to few borrowers or a few groups of borrowers or to a particular industrial sector or to a geographic region or country, etc;
iii. Counterparty credit risk which may be reflected in the relatively high Probability of Default(PD) or high Loss Given Default(LGD) of individual counterparties or of group of counterparties or at the overall bank level;
iv. Equity price risk arising from volatility in stock market index or major movements in prices of shares to which the bank has significant exposure;
v. Operational risk which may be due to the internal events such as the IT systems failure, internal frauds, disruption of services, etc. or due to the external events such as disruption of communication network, external frauds, etc;
vi. Liquidity risk arising from narrow depositors base, adverse cash flows, negative market perceptions or major rating downgrades, etc.
The above examples are for illustration only and the banks are expected to develop their own list of risk factors taking into account the nature of their business activities, the characteristics of their portfolios and their overall risk profiles.
6.2. Levels of Shocks
Banks may use the following levels of shocks to the individual risk factors taking into account the historical as well as hypothetical movement in the underlying risk factors:
i. Mild Level Shocks: These represent small shocks to the risk factors, which may vary for different risk factors;
ii. Moderate Level Shocks: These represent medium level shocks, the level of which may be defined for each risk factor separately;
iii. Severe Level Shocks: These represent severe shocks to all the risk factors and their level may also be defined separately for each risk factor. Such scenarios may reflect an extreme economic downturn or severe market conditions;
Banks are required to invariably choose and apply the three levels of shocks listed at points (i) to (iii) above to each of the identified risk factors. Furthermore, they are also required to conduct Reverse Stress Testing in line with Para 5.4 of these Rules.
6.3. Magnitude of Shocks
Banks are required to define the magnitude of the shock to be given to each of the identified risk factors separately for the above levels of shocks. They should take into account the following factors in defining the magnitude of the shock:
i. While determining the magnitude of shock, banks should review the historical pattern of worst events at portfolio level or at the level of specific business segment but this should not be the sole determinant of shock. Other qualitative factors and expert judgment should also guide this process;
ii. The time horizon for analyzing historical events should cover at-least one business cycle relevant to the underlying portfolio;
iii. The magnitude of the shock could be more than the worst historical movement in market value of the relevant portfolio but should not be so large or so small to render the stress testing exercise a hypothetical one;
iv. The magnitude of the shock should also take into account the prevailing market conditions, current operating environment and future perspectives;
v. The magnitude of the shock should be adequately varied for different levels of shock to assess the vulnerability of the bank under different scenarios;
vi. The magnitude of the shocks to be applied to the stress scenarios should be determined with reference to the “baseline” scenario and the magnitude for each level of shock should reflect an increasing level of stress when compared with the “baseline” position.
6.4. Scenario Assumptions
The results of stress tests and their interpretation is influenced by the underlying assumptions of stress testing. Therefore, banks should clearly outline the assumption made in drawing-up the list of relevant risk factors, determining the magnitude of shocks and the development of scenarios.
6.5. Development of Scenarios
Banks should develop a set of stress scenarios reflecting increasing levels of severity in line with the levels defined in Para 6.2 above. While developing the stress scenarios, banks should pay due regard to the following factors:
i. The selected stress scenarios should fully reflect the business environment and risk profile of individual banks;
ii. The scenarios may be based on historical events reflecting the actual experience of the bank or the banking industry in worst situations with appropriate adjustments, or non-historical/hypothetical ones based on a combination of factors including past experiences, prevailing market trends, future outlook and exercise of judgment;
iii. All material and significant risk factors having the potential to adversely affect the assets quality and profitability of the bank should be taken into account in scenario development;
iv. The scenarios should be comprehensive to cover the overall portfolio of the bank as well as its major business areas. Moreover, they should cover both on-balance sheet and off-balance sheet/contingent exposures;
v. Stress tests should include scenario(s) that could threaten the viability of the institution (reverse stress testing). Further guidance on selection of such scenario(s) has been provided in Section 5.4.