Stress and Scenario Analysis

Basel II has laid out detailed norms for stress test and scenario analysis. Areas covered include stress testing methodologies, scenario selection, supervision, etc. In the financial recession of 2008, many banks realized that they had not prepared themselves for a crisis that was so long drawn and deep. They came to the conclusion that the stress testing mechanisms they were using had perhaps underreported the risks. Stress testing helps send up red flags for possibly adverse outcomes. This enables the bank to create a capital cushion to absorb and tide over the crisis.

BIS defines stress test as follows: “A stress test is commonly described as the evaluation of a bank’s financial position under a severe but plausible scenario to assist in decision making within the bank. The term “stress testing” is also used to refer not only to the mechanics of applying specific individual tests, but also to the wider environment within which the tests are developed, evaluated and used within the decision-making process.”

According to BIS (Bank of International Settlements) stress testing is effective in:

  • Providing forward-looking assessments of risk;
  • Overcoming limitations of models and historical data;
  • Supporting internal and external communication;
  • Feeding into capital and liquidity planning procedures;
  • Informing the setting of a banks’ risk tolerance; and
  • Facilitating the development of risk mitigation or contingency plans across a range of stressed conditions.

When financial institutions tide over the crisis, it is still important to undertake these practices. It is also useful when, thanks to innovation, a scaling up of operations can occur as the organization goes into unchartered waters. Pillar I of Basel II stipulates that banks that use the internal models approach to ascertain market risk capital should have a rigorous stress testing procedure in place. Likewise it states that for banks having an Internal Ratings based approach for credit risk stress tests must validate the robustness of their internal capital assessments and the capital cushions above the regulatory minimum. It further states that banks must at least subject their credit portfolios in the banking book to stress tests. Taken in view of the banking crisis it was noted that the banks’ stress tests did not produce large loss numbers in relation to their capital buffers going into the crisis or capture their actual loss experience. If the banks’ had conducted firm-wide stress tests , with more severe scenarios, which might be considered tail end events they might have had far more realistic outcomes, closer to what eventually unfolded.

Stress tests are not the only risk assessing tool, but used as part of the banks comprehensive kit in risk assessment can be very powerful and help strengthen corporate governance and resilience of the bank.

At the ground level this would translate into guidelines a credit officer would use to conduct stress testing:

Historical stress: The bank’s credit department would once in a quarter run certain historical scenarios. Some examples included would be the Asian crisis, the Russian crisis and the oil crisis. Historical data from these crises are used to stress test current numbers in the books. The impact is measured and reported against current stress limits. When limits are exceeded, positions are readjusted. Now the correlation between different types of risks has been understood and established. In light of this the bank would undertake a unified risk stress test. A credit and market risk stress test would bring to focus ‘wrong way exposures’, since market risk almost immediately results in a higher probability of default by counterparties.

Potential stress scenarios: Based on market conditions in the near future and other possible developments, the credit officer may also come up with a set of possible scenarios that might occur. The credit committee would then define and review the scenarios.

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