7. Risk Coverage and Scenarios
Banks should cover all material and significant risks under their stress testing program. For this purpose , they should identify the major risk factors based on the assessment of their portfolios and its inherent vulnerabilities. The possible risk factors may include those related to credit, market, operational, liquidity and other risks. Banks should also capture the effect of reputational risk as well as integrate risks arising from off-balance sheet vehicles and other related entities in their stress testing program.
Some possible stress scenarios for stressing various risk factors are described in the following paragraphs. The scenarios listed hereunder are only for the reference of banks and should not be construed as an exhaustive list. Banks are expected to develop their own risk factors taking into account the nature of their business activities and the risks associated therewith. They should also determine the methodologies and techniques to be used for stressing the identified risk factors in line with the requirements of these Rules and the prevailing best practices.
7.1. Credit Risk
Credit risk is historically the most significant risk faced by the banks. It is measured by estimating the actual or potential losses arising from the inability or unwillingness of the obligors to meet their credit obligations on time. Banks may choose to conduct stress tests either under Standardized Approach or Internal Rating Based (IRB) Approach of *Basel-II. Furthermore, they may use a combination of risk parameters including Exposure at Default (EAD), Probability of Default (PD), Loss Given Default (LGD) and Maturity (M) to measure the credit risk.
Banks should conduct the stress tests on credit risk to estimate the impact of defined scenarios on their asset quality, profitability and capital. For this purpose, both on-balance sheet and off-balance sheet credit exposures should be covered. Some possible scenarios for conducting stress tests on credit risk are listed below:
i. Decrease in Oil Prices: Significant decrease in oil prices in the international market may affect the economic indicators of the country and possibly the credit portfolio of banks. The impact of significant reduction in oil prices on the asset quality, profitability and capital adequacy may be assessed;
ii. Economic Downturn: The adverse changes in major macro-economic variables may have implications for the quality of credit portfolio of banks. Banks may develop stress scenarios to assess the impact of adverse changes in economic variables like GDP, inflation, unemployment rate, etc. on their asset quality, profitability and capital adequacy. The unemployment rate and inflation may have direct impact on the quality of credit cards and personal loans.;
iii. Changes in LGDs and other Risk Parameters: Significant changes in LGDs, PDs, EAD, credit ratings, etc. of the obligors may heighten the credit risk of the bank. Banks may develop scenarios based on adverse changes in these credit risk parameters and assess the impact on their profitability and capital adequacy;
iv. Significant Increase in NPLs: Significant increase in non-performing loans (NPLs) due to multiple factors would adversely affect the asset quality and require additional provisioning. Such a scenario may involve increase in aggregate NPLs as well as downgrading all or part of the classified loans falling in various categories of classification by one notch. Banks may develop scenarios based on significant changes in the level of NPLs and their classification categories to assess the resultant impact on their provisioning requirements;
v. Slowdown in Credit Growth: Significant reduction in credit growth may adversely affect the income level and profitability. Banks may assess impact of marginal or negative growth in lending on their profitability and capital adequacy;
vi. Failure of Counterparties: Banks may have significant exposure to few counterparties or groups of related counterparties. Furthermore they might have significant exposure to few industrial sectors or geographic areas. Banks may develop scenarios to assess the impact of failure of their major counterparties or of increased default risk in a particular industry or geographic area on their profitability and capital adequacy.
Banks would develop their own scenarios taking into account the nature, size and mix of their credit portfolio. Furthermore, they should take into account the following factors while conducting stress tests on credit risk:
i. Stress tests may be conducted to cover the entire credit portfolio or selected credit areas like corporate lending, retail lending, consumer lending, etc. or a combination of both;
ii. Stress testing of corporate loans portfolio may involve the assessment of creditworthiness of individual borrowers and then aggregating the impact of risk factors on the portfolio level;
iii. Banks may use financial models to calculate the revised PDs and LGDs based on the selected scenarios and assess the impact thereof on the profitability and capital adequacy of the bank;
iv. Stress tests on consumer and retail loans may be conducted on portfolio level given the relatively large number and small value of such loans;
v. Banks having established internal credit rating systems may develop scenarios involving downgrading of the credit ratings of borrowers to assess the impact of identified risk factors on the quality of credit portfolio;
vi. The extreme but plausible events occurred over a business cycle may be taken into account in developing the relevant scenarios.
* This should be replaced with Basel III, Based on SAMA Circular on Basel III Reforms. 7.2. Market Risk
Market risk arises when the value of on- and off-balance sheet positions of a bank is adversely affected by movements in market rates or prices such as interest rates, foreign exchange rates, equity prices, credit spreads and/or commodity prices resulting m a loss to earnings and capital of the bank. Banks should conduct stress tests to test the resilience of their on- and off-balance sheet positions that are vulnerable to changes in market rates or prices in stressed situations. The stress tests for market risk may be conducted for the following risk factors:
7.2.1. Interest Rate Risk
Interest rate risk arises when there is a mismatch between positions, which are subject to interest rate adjustment within a specified period. The vulnerability of an towards the adverse movements of the interest rate can be gauged by using duration GAP analysis or similar other interest rate risk models, Interest rate risk may arise due to (i) differences between the timing of rate changes and the timing of cash flows (re-Pricing risk); (ii) changing rate relationships among different yield curves effecting bank’s activities (basis risk); (iii) changing rate relationships across the range of maturities (yield curve risk); and (iv) interest- related options embedded in bank products (options risk). Banks should conduct stress tests for interest rate risk keeping in view the nature and composition of their portfolios. Some plausible scenarios relating to interest rate risk may include the following:
i. Re-pricing Risk: Banks may develop stress scenarios to assess the impact on their profitability of the timing differences in interest rate changes and cash flows in respect of fixed and floating rate positions on both assets and liabilities side including off-balance sheet exposures;
ii. Basis Risk: This scenario would involve assessing the impact on profitability due to unfavorable differential changes in key market rates;
iii. Yield Curve Risk: This scenario may assess the impact on profitability due to parallel shifts in the yield curve (both up and down shifts) and non-parallel shifts in the yield curve (steeping or flattening of the yield curve);
iv. Option Risk: Banks may develop this scenario if they have significant exposure to option instruments. This would involve assessing the impact on profitability due to changes in the value of both stand-alone option instruments (e.g. bond options) and embedded options (e.g. bonds with call or put provisions and loans providing the right of prepayment to the borrowers) due to adverse interest rate movements.
7.2.2. Foreign Exchange Risk
Foreign Exchange risk is the current or prospective risk to earnings and capital arising from adverse movements in foreign exchange rates. It refers to the impact of adverse movement in exchange rates on the value of open foreign exchange positions. The overall net open position is measured by aggregating the sum of net short positions or the sum of net long positions; whichever is greater regardless of sign.
The stress test for foreign exchange risk assesses the impact of change in exchange rates on the profitability. Such stress test may focus on the overall net open position of the bank including the on-balance sheet and off-balance sheet exposures. Some plausible scenarios relating to foreign exchange risk may include the following:
i. Appreciation in Exchange Rates: Banks may develop stress scenarios to assess the impact of certain assumed levels of appreciation in the relevant exchange rates in case they have significant cross currency exposures;
ii. Depreciation in Exchange Rates: Banks may develop stress scenarios to assess the impact of certain assumed levels of depreciation in the relevant exchange rates on their open foreign exchange positions;
Banks may develop such scenarios based on the significance and level of their open foreign exchange positions.
7.2.3. Equity Price Risk
Equity price risk is the risk to the earnings or capital of the bank that results from adverse changes in the value of its equity related portfolios. The equity price risk may arise from changes in the value of a bank’s equity investment portfolio either due to the adverse movements in the overall level of equity prices/stock markets indices or as a result of the price volatility in shares forming part of the bank’s portfolio. Some plausible stress scenarios relating to equity price risk may include the following:
i. Fall in stock market Indices: Banks may develop stress scenarios to assess the impact of certain assumed levels of decline in the stock market indices on their earnings and capital;
ii. Drop in value of portfolio: If the bank holds an equity portfolio highly concentrated in few sectors or few companies, it may conduct stress tests based on the assumed changes in the related sectoral stock indices or prices of shares forming major part of its portfolio;
iii. Drop in Collateral Coverage: Banks active in margin lending may conduct stress tests to assess the impact of decline in stock prices/indices on the collateral coverage level of their margin loans and the resulting impact on their earnings and capital.
While conducting stress tests for equity price risk, banks should cover both the on- balance sheet as well as off-balance sheet equity portfolios.
7.2.4. Commodity Price Risk
Commodity price risk is the risk to the earnings or capital of the banks, particularly those engaged in Sharia’h compliant banking, that results from the current and future volatility of market values of specific commodities. If a bank is exposed to commodity price fluctuations, it should develop appropriate scenarios to conduct stress test for commodity price risk. The bank should assesses the impact of changes in commodity prices on its profitability and capital adequacy.
7.3. Liquidity Risk
Liquidity risk is the risk of potential loss to a bank due to either its inability to meet its obligations in a timely manner or its inability to fund increases in assets /conduct a transaction at the prevailing market prices. The liquidity risk may arise from various sources including the significant mismatches in maturity structure of assets and liabilities, changes in interest rates which may encourage depositors to withdraw their deposits to seek better returns elsewhere, downgrading of credit rating and adverse market reputation which may pose challenges in accessing fresh liquidity, etc. Furthermore, derivatives and other off-balance sheet exposures may also become a source of liquidity risk and, therefore, banks should take into account the impact of off-balance sheet items and commitments in undertaking stress testing. Banks should analyze their liquidity position to assess their resilience to cope with stress situations. Some plausible stress scenarios relating to liquidity risk may include the following:
i. Deposits Withdrawals: Banks may develop scenarios of significant deposits withdrawals or major shifts in different categories of deposits e.g. from current deposits to term deposits, and analyze their impact on their liquidity and funding costs. The banks may assume different levels of withdrawals for current, savings and term deposits, and for local and foreign currency deposits;
ii. Tightening of Credit Lines: The banks which are heavily reliant on inter-bank borrowing should develop scenarios involving tightening or withdrawal of available inter-bank credit lines, identify alternate sources of funding and estimate the impact of such changes on the funding cost and profitability of the bank;
iii. Significant Maturity Mismatches: Such scenarios may be involved assumed widening of gaps in the overall and individual maturity buckets of total assets and liabilities as well as in the rate sensitive assets and liabilities, and assessing their implications for the liquidity management;
iv. Repayment Behavior of Borrowers: Banks may develop scenarios linking the level of projected cash flows with different assumed patterns of loan repayments. For instance, a stress scenario may assume delayed payment or prepayment of loans by some large borrowers and assess the impact thereof on liquidity position and earnings of the bank.
Banks may assess the resilience of their liquidity position by calculating the ratio of liquid assets to liquid liabilities” before and after the application of shocks. For this purpose, the liquid assets are the assets that can be easily and cheaply turned into cash and includes cash, balances with other banks and SAMA, inter-bank lending/placements, lending under repo and investment in government securities. The liquid liabilities includes the short-term deposits and borrowings. The ratio of liquid assets to liquid liabilities may be recalculated under each scenario to analyze the changes in liquidity position.
7.4. Operational Risk
Operational risk is the risk of loss resulting from both internal and external operational events including e.g. technology failures, business disruption and system failures, breaches in internal controls, frauds, or other operational problems that may result in unexpected losses for the bank. The banks should systematically track and record frequency, severity and other information on operational loss events to provide a meaningful information for assessing the bank’s exposure to operational risk and developing a policy to mitigate / control that risk.
Banks should develop stress scenarios for operational risk stress tests based on the data of their past operational loss events and using professional judgment. The assumptions for operational risk stress tests would be different from those used in credit and market risk stress tests, and should be based on historical and plausible hypothetical operational loss events. A plausible stress scenario may assume a major business disruption or system failure (e.g. due to hardware or software failure or telecommunication problems) and assesses the effects of such disruptions /failures on the earnings and capital of the bank. Any additional capital requirements emanating from the outcome of operational risk stress tests should be taken into account in the capital planning process.
7.5. Other Risks
The risks and scenarios mentioned above are for the guidance of banks and this list may not be exhaustive. Banks are encouraged to identify any other risks and vulnerabilities related to their business and develop appropriate scenarios to stress those risks. They should identify the sources of risks using the guidance provided in these Rules and their own experiences, and then narrow down the list to significant risks potentially having material impact on their business and financial condition. Focusing on the material risks would enable banks to conduct the stress testing exercise in a meaningful way.