RBI
/ 2006-07/ 444
DBOD. No. BP.
BC.101 / 21.04.103/ 2006-07
June
26, 2007
The
Chairman/ Chief Executive Officer
All
Commercial Banks
(excluding
RRBs & LABs)
Dear
Sir,
Guidelines
on Stress Testing
Improvement
in risk management practices has been in focus since the introduction of the financial
sector liberalization process in the mid nineties. The process gained momentum
with the issue of regulatory guidelines and guidance notes on asset liability
management and management of credit risk, market risk and operational risk by
the Reserve Bank since 1999. Further, the announcement of implementation of the
revised capital adequacy framework in India has brought the risk management capabilities
of banks into greater focus.
2.
Globally, banks are increasingly relying on statistical models to measure and
manage the financial risks to which they are exposed. These models are gaining
credibility because they provide a framework for identifying, analysing, measuring,
communicating and managing these risks. Since models cannot incorporate all possible
risk outcomes and are generally not capable of capturing sudden and dramatic changes,
banks supplement models with ‘stress tests’. Internationally, stress testing has
become an integral part of banks’ risk management systems and is used to evaluate
the potential vulnerability to some unlikely but plausible events or movements
in financial variables. There are broadly two categories of stress tests used
in banks viz. sensitivity tests and scenario tests. These may be used either separately
or in conjunction with each other.
Sensitivity
tests are normally used to assess the impact of change in one variable
(for example, a high magnitude parallel shift in the yield curve, a significant
movement in the foreign exchange rates, a large movement in the equity index etc.)
on the bank’s financial position.
Scenario
tests include simultaneous moves in a number of variables
(for example, equity prices, oil prices, foreign exchange rates, interest rates,
liquidity etc.) based on a single event experienced in the past (i.e., historical
scenario – for example, natural disasters, stock market crash, depletion of
a country’s foreign exchange reserves) or a plausible market event that has not
yet happened (i.e., hypothetical scenario - for example, collapse of communication
systems across the entire region/ country, sudden or prolonged severe economic
downturn) and the assessment of their impact on the bank’s financial position.
3.
Banks in India are beginning to use statistical models to measure and manage risks.
Stress tests are, therefore, relevant for these banks. Notwithstanding the use
of statistical models, stress tests are a relevant and integral part of banks'
risk management frameworks. Further, the supervisory review process under Pillar
2 of Basel II framework is intended not only to ensure that banks have adequate
capital to support all the risks in their business, but also to encourage banks
to develop and use better risk management techniques in monitoring and managing
their risks. In the above background, the need for banks in India to adopt ‘stress
tests’ as a risk management tool has been emphasised in the Annual Policy Statement
for 2006-07. Accordingly, the draft guidelines on stress testing were prepared
and issued for feedback from banks. On the basis of the feedback received, the
draft guidelines have been suitably revised and are furnished in the Annex
. Guidelines on stress testing, as relevant for the Basel II framework, will be
issued separately.
4.
A copy of this circular may be placed before the Board of Directors at the next
meeting for their information and appropriate guidance / advice. Banks shall put
in place appropriate stress test policies and the relevant stress test framework
for the various risk factors by September 30, 2007. As it is appreciated that
banks may need to undertake the stress tests on a trial basis and use the results
of these trial tests as a feedback to further refine the framework, it has been
decided that banks be allowed some time to refine the stress testing frameworks.
Banks are required to ensure that their formal stress testing frameworks, which
are in accordance with the guidelines in Annex, are operational from March 31,
2008.
5.
Please acknowledge receipt.
Yours
faithfully,
(Prashant Saran)
Chief General
Manager – in – Charge
ANNEX
Guidelines
to banks on Stress Testing
Background
1.
Internationally, stress testing has become an integral part of a bank’s risk management
system and is used to evaluate its potential vulnerability to certain unlikely
but plausible events or movements in financial variables. The vulnerability is
usually measured with reference to the bank’s profitability or / and capital adequacy.
This brings to fore the inadequacies of managing risks on the basis of ‘normal’
business conditions and emphasises the importance of robust risk management systems
which factor-in a forward looking element and recognise the need to manage risks
‘over the economic cycle’.
2.
There are broadly two categories of stress tests used in banks viz. sensitivity
tests and scenario tests. These may be used either separately or in conjunction
with each other. The stress events and scenarios identified / developed by a bank
should be plausible and relevant to its portfolio.
Sensitivity
tests are normally used to assess the impact of change in one variable
(for example, a high magnitude parallel shift in the yield curve, a significant
movement in the foreign exchange rates, a large movement in the equity index etc.)
on the bank’s financial position.
Scenario
tests include simultaneous moves in a number of variables
(for example, equity prices, oil prices, foreign exchange rates, interest rates,
liquidity etc.) based on a single event experienced in the past (i.e., historical
scenario – for example, natural disasters, stock market crash, depletion of
a country’s foreign exchange reserves) or a plausible market event that has not
yet happened (i.e., hypothetical scenario - for example, collapse of communication
systems across the entire region/ country, sudden or prolonged severe economic
downturn) and the assessment of their impact on the bank’s financial position.
Utility
3.
A well designed and implemented stress testing framework would supplement banks’
risk management systems and help in making these systems more robust. The stress
testing framework also helps banks to be better equipped to meet the stress situations
as and when they arise and also overcome them such that they do not become a serious
threat to themselves or to the banking systems in which they operate.
4.
Stress tests should, as far as possible, be conducted on a bank-wide basis. While
applying the stress tests on a bank-wide basis, due consideration should be given
to country or market or portfolio specific factors. Stress tests should be adequately
tailored to capture these factors. Stress tests undertaken on a bank-wide basis
enable the Board and senior management to assess the potential impact of the stress
situations on the bank’s earnings and capital position, and enable them to develop
or choose appropriate strategies for mitigating and managing the impact of those
situations. The framework also helps bank managements in understanding the bank’s
risk profile and adjusting it in accordance with their risk appetites. The stress
test results should be considered while establishing and reviewing various policies
and limits.
5.
The stress testing frameworks perform the dual role of being a diagnostic tool
for improving a bank’s understanding of its risk profile, for assessing the adequacy
of internal capital, for supplementing the internal capital models where paucity
of historical data limits the predictive power of the models, and for introducing
a forward looking element in the capital assessment process. Banks need to understand
the likely impact of the stress situations and relate it to the capacity of the
bank’s profitability to absorb the shocks and the consequent impact on the bank’s
capital. Considering the range of possible options to tackle the stress situations,
banks may decide to hold a capital buffer that would be aligned to the exceptional
but plausible stress situations. The stress testing framework will serve as an
important component of banks’ Internal Capital Adequacy Process (ICAAP) under
the Basel II framework. Guidelines on stress testing, as relevant for the Basel
II framework, will be issued separately.
Framework
requirements
6.
Banks shall put in place a Board approved ‘Stress Testing framework’ to suit their
individual requirements which would integrate into their risk management systems.
The framework should satisfy the following essential requirements:
i)
The Board approved ‘stress testing policy’ should detail (a) the frequency and
procedure for identifying the principal risk factors which affect the bank’s portfolio
and should be stressed; (b) the methodology for constructing appropriate and plausible
single factor and multi factor stress tests; (c) the procedure for setting the
stress tolerance limits; (d) the process for monitoring the stress loss limits;
(e) the remedial actions required to be taken at the relevant stages; (f) the
authorities designated to activate the remedial actions; (g) the need for identification
of the responsibilities assigned to various levels/ functional units; and (h)
the need for specification of reporting lines.
ii)
The senior management should be actively involved in identifying the principal
risk factors; designing appropriate single factor/ multi factor stress tests;
setting the stress tolerance limits; reviewing the stress test results and monitoring
the stress loss limits; activating the appropriate remedial actions; periodically
communicating the stress test results and the actions taken, if any, to the Board;
reviewing the need to modify the stress testing framework with reference to certain
elements like the risk factors, stress scenarios, levels of stress to be applied,
the underlying assumptions, stress tolerance levels, remedial actions etc.; designing
an appropriate MIS to support the stress tests to be conducted; and ensuring an
appropriate and effective internal control mechanism to validate the stress tests
and their findings;
iii)
Board and senior management should regularly review the results of scenario analyses
and stress tests, including the major assumptions that underpin them. Stress test
results may be used for setting risk limits; allocating capital for various risks;
managing risk exposures; and putting in place appropriate contingency plans for
meeting the situations that may arise under adverse circumstances.
iv)
Stress testing framework should be calibrated according to the complexity of each
bank’s business activities. The number of risk factors to be stressed would depend
on the complexity of the portfolio and the risks the bank is exposed to. Banks
should be able to justify their choice of stress tests and the choice of risk
factors that are stressed. Banks which have foreign operations, or/ and are active
in derivatives markets, or/ and are operating an active trading portfolio should
use a combination of scenario analysis and sensitivity tests. Other banks may
confine themselves to sensitivity tests run relatively more frequently to assess
the impact of the relevant principal risk factors on their financial condition.
v)
Banks are free to choose the various assumptions underlying the stress tests and
the basis for their assumptions. However, these should be well documented and
available for verification by the supervisor / auditors. The assumptions underlying
the stress tests should be reviewed periodically for assessing their validity.
Banks should undertake fresh stress tests when there are significant modifications
in the underlying assumptions. Such periodic reviews are necessary to ensure the
integrity, accuracy, and reasonableness of the stress testing framework.
vi)
Banks should use appropriate, accurate and complete data when performing stress
tests. The IT resources should be commensurate with the complexity of the techniques
and the coverage of the stress tests. Banks should have adequate MIS in place
to support the stress testing framework. The systems should be able to support
the conduct of stress tests on different risks at relevant levels (portfolios,
regions, business units) and also aggregate the results for the bank as a whole.
vii)
As the environment in which banks are operating is quite dynamic, there are changes
in macroeconomic environment, banks’ instruments, trading strategies and regulatory
policies. The risk measurement methodologies and stress testing techniques in
banks should, therefore, evolve to accommodate these changes. The stress testing
framework should, therefore, be reviewed periodically to determine its efficacy
and to consider the need for modifying any of the elements. The framework should
be subjected to at least annual reviews which should cover, among others, the
following aspects:
(a)
Adequacy of the documentation for various elements of the stress testing framework;
(b)
Integration of the stress testing framework in the day-to-day risk management
processes;
(c) Scope of coverage
of the framework and the levels of stress applied;
(d)
Integrity of MIS and data feeding into the stress tests; and
(e)
Adequacy of the remedial actions and the efficiency of the systems for their activation;
Identification
of risks
7.
While traditionally stress tests are used in the context of managing market
risks, these may also be employed in the management of credit risks, operational
risks and liquidity funding risk. Banks should identify their major risks
that should be subjected to stress tests. While identifying the major risks, banks
should understand their exposures and the risks to which these are exposed as
well as the correlation between these risks. An indicative list of the risks that
banks, in general, are exposed to are credit risk, credit concentration risk,
interest rate risk, price risk, foreign currency risk, impact of market movements
on contingent credit risk, liquidity risk, operational risks, prepayment risk,
model risk, macro economic risk and political risk. The above is only an indicative
list and banks should identify the risks to which they are exposed to with regard
to their bank specific circumstances and portfolio.
Stress
scenarios / levels
8.
Banks should stress the relevant parameters at least at three levels of increasing
adversity – minor, medium, and major – with reference to the normal situation
and estimate the financial resources needed by it under each of the circumstances
to
a)
meet the risk as it arises and for mitigating the impact of manifestation of that
risk;
b) meet the liabilities
as they fall due; and
c)
meet the minimum CRAR requirements.
9.
A scenario analysis measures the combined effect of adverse movements in more
than one risk factor. Banks should determine the various risks that should be
included in a scenario, take into account the linkages among the various risks
without looking at each of them in isolation and assess the extent to which the
stress would impact their financial position. Stress scenarios may be designed
on the basis of either historical events or hypothetical events. An important
element of scenario development will be the assessment and incorporation of the
linkages between the various risk factors.
10.
A few examples of stress factors / scenarios are as follows: domestic economic
downturn, economic downturn of major economies to which the bank is directly exposed
or to which the domestic economy is related; decline in the prospects of sectors
to which the banks are having significant exposures; increase in level of NPAs
and provisioning levels; increase in level of rating downgrades; failure of major
counterparties; timing difference in interest rate changes (repricing risk); unfavourable
differential changes in key interest rates (basis risk); parallel / non parallel
yield curve shifts (yield curve risk); changes in the values of standalone and
embedded options (option risk); adverse changes in exchange rates of major currencies;
decline in market liquidity for financial instruments; stock market declines;
tightening of market liquidity; significant operational risk events.
Frequency
of stress testing
11.
Banks may apply stress tests at varying frequencies dictated by their respective
business requirements, relevance and cost. While some stress tests may be conducted
daily or weekly – for example: trading book items for the various market risks;
some others may be conducted at monthly or quarterly intervals – for example:
those items which are less volatile in nature like credit risk in loans or HTM
securities; interest rate risk in the banking book; and liquidity risk. Further,
ad-hoc stress tests may be warranted when there are any special circumstances
– for example: a rapidly deteriorating political / economic conditions in a country
may warrant a quick assessment of the likely impact on the bank on account of
its exposures to that country.
Interpretation
of stress test results
12.
The results of the various stress tests should be reviewed by the senior management
and reported to the Board. These results should be an essential ingredient of
bank’s risk management systems.
13.
Banks should be conscious of the fact that the stress tests only indicate the
likely impact and do not indicate the likelihood of the occurrence of the stress
events. Since stress testing is influenced by the judgment and experience of the
people who design the stress tests, the effectiveness of the stress tests will
depend upon whether banks have identified their major risks, whether they have
chosen the right level of stress / stress scenarios, whether they have understood
and interpreted the stress test results properly and whether they have initiated
the necessary steps to address the situation presented by the stress test results.
Hence, each of the above aspects need to be assigned their due importance.
14.
Banks should document the stress tests undertaken by them, the underlying assumptions,
the results and the outcomes. The documentation should be preserved at least
for five years.
Remedial
Actions
15.
The remedial actions that banks may consider necessary to activate when the various
stress tolerance levels are breached may include:
a)
Reduction of risk limits;
b)
Reduction of risks by enhancing collateral requirements, seeking higher level
of risk mitigants, undertaking securitisation, and hedging;
c)
Amend pricing policies to reflect enhanced risks or previously unidentified risks;
d)
Augmenting the capital levels to enhance the buffer to absorb shocks;
e)
Enhancing sources of funds through credit lines, managing the liability structure,
altering the liquid asset profile, etc.;
16.
Banks should clearly identify the principles that they would be guided by while
they decide on activation of the various remedial actions as appropriate to the
stress event / level that may be reflected in the stress test results. The triggers
for remedial actions may be identified clearly for example: with reference to
the size of the potential loss or the impact on earnings and / or capital. In
addition, the level of authority for determining the remedial action to be initiated
should be clearly identified. The triggers, the remedial actions, the guiding
principles for activation and the designated authorities should be properly documented
and adopted/ applied as and when relevant.
17.
As stress testing is an evolving area, a few illustrative examples
of typical stress tests are presented in the Attachment
purely with a view to aid in better perception of stress tests. Therefore, it
would not be appropriate (i) to conclude that the levels of stress
or the impacts mentioned in the illustrations are as perceived by the Reserve
Bank or are recommended by the Reserve Bank and (ii) for banks to apply the illustrative
stress tests as they are. Each bank should ensure that the assumptions and the
levels of stress are as determined by them and that the stress tests are suitably
modified while designing their respective stress testing frameworks. The stress
testing framework and methodology in each bank should be tailored to suit the
size, complexity, risk philosophy, risk perceptions and skills in each bank.
Effective
Date
18.
Banks shall put in place appropriate stress test policies and the relevant stress
test framework for the various risk factors by September 30, 2007. As it is appreciated
that banks may need to undertake the stress tests on a trial basis and use the
results of these trial tests as a feedback to further refine the framework, it
has been decided that banks be allowed some time to refine the stress testing
frameworks. Accordingly, banks may use the next 6 months to test and refine the
stress testing framework and the under lying assumptions. At the same time, with
a view to ensuring that stress testing frameworks for all relevant risk factors
are formally operational in the Indian banking system without much delay, banks
are required to ensure that their formal stress testing frameworks, which are
in accordance with these guidelines, are operational from March 31, 2008.