12. Stress Testing
No: BCS 290 Date(g): 12/6/2006 | Date(h): 16/5/1427 Status: No longer applicable Please Refer to SAMA's Rules on stress testing for the updated requirements on stress testing.Stress Testing is a generic term for the assessment of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'. Stress testing 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.
12.1 Stress Testing Under Pillar 1
The Basel II document has several references for banks to develop and use stress testing methodology to support their work on credit, market and operational risks. There are several reference to stress testing under Pillar 1 which are summarized hereunder:
Para 434 An IRB Bank must have in place sound stress testing processes for use in the assessment of capital adequacy. Examples of scenarios that could be used are (i) economic or industry downturn (b) market-risk events (c) liquidity conditions. Para 435 The bank must perform a credit risk stress test to assess the effect of certain specific conditions on its IRB regulatory capital requirements. The bank's stress test in this context should consider at least the effect of a mild recession scenario e.g. two consecutive quarters of zero growth to assess the impact on its PD's, LGD's and EAD's. Para 436 The bank's method should consider the following sources of information: bank's own data should allow estimation of the ratings migration; impact of a small deterioration in credit environment on a bank's rating; evaluate evidence of rating migration in external ratings. Para 437 National discretion with supervisors to issue guidance on design of stress tests. 12.2 Additional Pillar 1 Guidance on Stress Testing
Para 527(j) For calculation of capital charge for equity exposures where internal models are used there are some minimum quantitative standards to be applied. One of these standards requires that a rigorous and comprehensive stress testing program must be in place. In addition, under the Basel Market Risk Amendment document of 1996 there are stress testing requirements for banks using the internal models. These are contained in Section B.5 of the (1996) Amendment and are as follows:
• Among more qualitative criteria that banks would have to meet before they are permitted to use a models based approach are the following:
• 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 capital to absorb potential large losses and to identify steps the bank can take to reduce its risk and conserve capital.
• Results of stress testing should be routinely communicated to senior management and periodically, to the bank's board of directors.
• Results of stress tests should be reflected in the policies and limits set by the management.
• Prompt steps are expected for managing revealed risks appropriately, e.g.
• Hedging
• Reducing size of exposures
• Scenarios to be employed:
• Historical without simulation (largest losses experienced)
• Historical with simulation (assessing effects of crisis scenarios or changes in underlying parameters on current portfolios)
• Mostly for adverse events, based on individual portfolio characteristics of institutions
12.3 Stress Testing Under Pillar 2
Under the Supervisory Review Process SAMA will initially review the Pillar 1 stress testing requirement for credit and market risks. How-ever, the Basel II document also covers stress testing under Pillar 2 and the relevant references are included in the following paragraphs:.
Para 726 In assessing capital adequacy, bank management needs to be mindful of the particular stage of the business cycle in which the bank is operating. Rigorous, forward looking stress testing that identifies possible events or changes in market conditions that could adversely impact the bank should be performed. Bank management clearly bears primary responsibility for ensuring that the bank has adequate capital to support its risks. Para 738 For market risk this assessment is based largely on the bank's own measure of value-at-risk or the standardised approach for market risk. Emphasis should also be placed on the institution performing stress testing in evaluating the adequacy of capital to support the trading function. Para 775 For credit concentration risk a bank's management should conduct periodic stress tests of its major credit risk concentrations and review the results of those tests to identify and respond to potential changes in market conditions that could adversely impact the bank's performance. Para 777 In the course of their activities, supervisors should assess the extent of a bank's credit risk concentrations, how they are managed, and the extent to which the bank considers them in its internal assessment of capital adequacy under Pillar 2. Such assessments should include reviews of the results of a bank's stress tests. Para 804 Under Securitization banks should use techniques such as static pool cash collections analyses and stress tests to better understand pool performance. These techniques can highlight adverse trends or potential adverse impacts. Banks should have policies in place to respond promptly to adverse or unanticipated changes. Supervisors will take appropriate action where they do not consider these policies adequate. Such action may include, but is not limited to, directing a bank to obtain a dedicated liquidity line or raising the early amortisation credit conversion factor, thus, increasing the bank's capital requirements. 12.4 Other Aspects Related to Stress Testing
12.4.1 There are no specific or explicit requirements in the Basel II document on stress testing for liquidity risk although some banks may wish to develop 'What if' scenarios for liquidity under stress conditions.
12.4.2 SAMA expects all banks to closely review the above Basel II recommendations on stress testing and develop specific strategies and methodologies to implement those that are relevant and appropriate for their operations. The Agency in its evaluation of banks method and systems under Pillar I 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.
12.4.3 As a minimum banks should carryout stress tests at least on an annual basis.
3361