1.A Bank must have a forward-looking stress-testing program that addresses market risks as well as other Pillar 1 risks and any relevant Pillar 2 risks. Consideration of market risks must include liquidity implications as well as impacts on earnings and capital.
2.A Bank’s stress scenarios must cover a range of market risk factors that can create extraordinary losses or gains in trading portfolios, or make the control of risk in those portfolios very difficult. Stress scenarios need to shed light on the impact of such events on positions that display both linear and nonlinear price characteristics (for instance options and instruments that have options-like characteristics).
3.A Bank’s stress tests must be both of a quantitative and qualitative nature, incorporating both market risk and liquidity aspects of market disturbances. Quantitative criteria must identify plausible stress scenarios to which a Bank could be exposed. Qualitative criteria must emphasize that the two major goals of stress testing are to evaluate the capacity of the Bank’s capital to absorb potential large losses and to identity steps the Bank can take to reduce its risk and conserve capital. This assessment is integral to setting and evaluating the Bank’s management strategy and the results of stress testing routinely must be communicated to Senior Management and periodically to the Board.
4.From time to time, the Central Bank may require Banks to carry out stress tests based on Central Bank prescribed scenarios. A Bank must combine the use of stress scenarios as prescribed by the Central Bank with internally developed stress tests to reflect the specific risk characteristics of its portfolio. A Bank must submit the following information on stress testing to the Central Bank:
a.Supervisory scenarios requiring no simulations by a Bank: A Bank must make information on the largest losses experienced during the reporting period available to the Central Bank. This loss information must be compared to the level of capital that results from a Bank’s internal measurement system. For example, it could provide the Central Bank with a picture of how many days of peak day losses would have been covered by a given value-at-risk or expected shortfall estimate;
b.Supervisory scenarios requiring simulations by a Bank: A Bank must subject its portfolios to a series of simulated stress scenarios and provide the Central Bank with the results. These scenarios could include testing the current portfolio against past periods of significant disturbance. A second type of scenario would evaluate the sensitivity of the Bank’s market risk exposure to changes in the assumptions about volatilities and correlations. Applying this test would require an evaluation of the historical range of variation for volatilities and correlations and evaluation of the Bank’s current positions against the extreme values of the historical range. Due consideration must be given to the sharp variation that at times has occurred in a matter of days in periods of significant market disturbance. (for example, the global financial crisis and earlier major market disturbances involved correlations within risk factors approaching the extreme values of 1 or −1 for several days at the height of the disturbance); and
c.Scenarios developed by the Bank itself to capture the specific characteristics of its portfolio: A Bank must develop its own stress tests which it identifies as most adverse based on the characteristics of its portfolio (such as adverse regional developments combined with a sharp move in oil prices). The market shocks applied in the tests must reflect the nature of portfolios and the time it could take to hedge or manage risks under severe market conditions. The Bank must provide the Central Bank with a description of the methodology used to select and carry out the scenarios as well as with a description of the results derived from these scenarios. The stress tests must also address:
i.Illiquidity/gapping of prices;
ii.Concentrated positions (in relation to market turnover);
vi.Other risks that may not be captured appropriately in the models (in the case of VaR models for example, these may include but are not limited to: recovery rate uncertainty, implied correlations, skew risk, default risk, migration risks and shocks to the exchange rate regime).
5.Senior Management must review the stress test results periodically, but at least monthly and such results must be reflected in the policies and limits set by management and the Board. Stress test results must be used in the internal assessment of capital adequacy. The Bank must take prompt steps to manage vulnerabilities identified in stress testing, which can include but are not limited to hedging against identified outcomes, reducing the size of exposures or increasing capital.