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Effective from Nov 23 2011 - Nov 22 2011
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  • 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.