Stress Testing project

8/7/2019 Stress Testing project

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EXECUTIVE SUMMARY

The project I undertook was to study the importance of treasury risk management

and stress testing under the same. Main objective behind this is to know about the importance of

stress testing in India and to understand the working of the same. In India, risk management

techniques especially are developing at a very slow pace as compared to international banking

industry.

The project contains study and understanding of the treasury departments in banks,

what are the major components of treasury department, developing role and importance of

stress testing in the Indian banking industry

I got a wide exposure of treasury department while working on the project. I also

understood working of this department and how it is different from other department, products

of banks.

PROJECT TITLE

Integrated Treasury with emphasis on risk management Stress Testing


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TABLE OF CONTENTS

SR.NO PARTICULARS PAGE NOS.

1 Executive Summary1

3 Objective of treasury operations in Banks11

4 Risk Management 13

6 Risk management of Treasury operations in banks 17

7 Stress Testing 21

8 Stress testing guidelines and mechanism 24

9 Stress Tests: Testing Financial Health 29

10 Case of Stress Testing in Nigerian Banks 34

11 Conclusions 36


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12 Bibliography 37


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Objective of treasury operations in Banks

1. Reserve Management & Investment: It involves

(i) Meeting CRR / SLR obligations

(ii) Having an appropriate mix of investment portfolio to optimize yield and duration.

Duration is the weighted average life of a debt instrument over which investment in

that instrument is recouped. Duration Analysis is used as a tool to monitor the price

sensitivity of an investment instrument to interest rate changes.

2. Liquidity & Funds Management: It involves

(i) Analysis of major cash flows arising out of asset-liability transactions

(ii) Providing a balanced and well-diversified liability base to fund the various assets in

the balance sheet of the bank

(iii) Providing policy inputs to strategic planning group of the bank on funding mix

(currency, tenor & cost) and yield expected in credit and investment.

3. Asset Liability Management & Term Money: ALM calls for determining the optimal size

and growth rate of the balance sheet and also prices the Assets and Liabilities in

accordance with prescribed guidelines. Successive reduction in CRR rates and ALM

practices by banks increase the demand for funds for tenor of above 15 days (Term

Money) to match duration of their assets.

4. Risk Management - Integrated treasury manages all market risks associated with a

banks liabilities and assets. The market risk of liabilities pertains to floating interest

rate risks and asset & liability mismatches. The market risk for assets can arise from

(i) Unfavorable change in interest rates

(ii) Increasing levels of disintermediation

(iii) Securitization of assets

(iv) Emergence of credit derivatives etc.

While the credit risk assessment continues to rest with Credit Department, the Treasurywould monitor the cash inflow impact from changes in asset prices due to interest rate

changes by adhering to prudential exposure limits.

5. Transfer Pricing: Treasury is to ensure that the funds of the bank are deployed

optimally, without sacrificing yield or liquidity. An integrated Treasury unit has an idea

of the banks overall funding needs as well as direct access to various markets (like

money market, capital market, forex market, credit market). Hence, ideally treasury


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should provide benchmark rates, after assuming market risk, to various business groups

and product categories about the correct business strategy to adopt. f. Derivative

Products: Treasury can develop Interest Rate Swap (IRS) and other Rupee based / cross -

currency derivative products for hedging Banks own e xposures and also sell such

products to customers/other banks. g. Arbitrage: Treasury units of banks undertake this

by simultaneous buying and selling of the same type of assets in two different markets

to make risk-less profits.

6. Capital Adequacy: This function focuses on quality of assets, with Return on Assets

(RoA) being a key criterion for measuring the efficiency of deployed funds.

An integrated treasury is a major profit centre. It has its own P & L measurement. It

undertakes exposures through proprietary trading (deals done to make profits out of

movements in market interest /exchange rates) that may not be required for general

banking.

Risk Management

Risk is inherent part of Banks business. Effective Risk Management is critical to any

Bank for achieving financial soundness. In view of this, aligning Risk Management to

Banks organizational structure and business strategy has become integral in banking

business. Over a period of year, Union Bank of India (UBI) has taken various initiatives

for strengthening risk management practices. Bank has an integrated approach formanagement of risk and in tune with this, formulated policy documents taking into

account the business requirements / best international practices or as per the guidelines

of the national supervisor. These policies address the different risk classes viz., Credit

Risk, Market Risk and Operational Risk.

The issues related to Credit Risk are addressed in the Policies stated below;

Loan Policy.

Credit Monitoring Policy.

Real Estate Policy.

Credit Risk Management Policy.

Collateral Risk Management Policy.

Recovery Policy.

Treasury Policy.

The Policies and procedures for Market Risks are articulated in the ALM Policy and


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Treasury Policy.

The Operational Risk Management involves framework for management of operational

risks faced by the Bank. The issues related to this risk is addressed by;

Operational Risk Management Policy.

Business Continuity Policy.

Outsourcing Policy.Disclosure Policy.

Besides, the above Board mandated Policies, Bank has detailed Internal Control

Principles communicated to the business lines for ensuring adherence to various norms

like Anti-Money Laundering, Information Security, Customer complaints, Reconciliation

of accounts, Book-keeping etc.

Risk management of Treasury operations in banks

BANK managements are highly sensitive to Treasury risks, as they arise out of the highleverage of the Treasury business. The risk of losing capital is much higher than, say, inthe credit business. The second reason for managements' concern is the large s ize of thetransaction done, at the sole discretion of the treasurers. The conventional control andsupervisory measures, mostly in the nature of preventive steps, can be divided intothree parts:

Organizational controls: This refers to the checks and balances within the system.Treasury is divided in two parts the front and back office. The front office generatesdeals and the back office settles trades only after verifying compliance with the internalcontrols.

Exposure limits: These caps are put in place to protect the bank from credit risk,which, in Treasury, may be of defaulters and counter party.

Internal controls: The most important of the internal controls are position and stop -

loss limits. The trading limits are of three kinds:

a) On deal size,

b) On open positions, and

c) Stop-loss.


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Treasury faces Market Risk (which broadly covers that of liquidity, interest rate,exchange rate and equity price); credit risk, and operational risk.

Market risk management

Treasury investments are categorized into government securities, other approved

securities, shares, debentures and bonds, commercial papers, and mutual funds. In linewith international best practices, the investments are classified into three categories Held to Maturity, Available for Sale and Held for Trading. The investments made to earnprofits from the short-term price movements are classified under the Held-for-TradingCategory, whereas the securities contracted basically on account of relationship or forsteady income and statutory obligations are classified under Held-To-Maturity (HTM)category. The securities, which do not fall under these categories, are classified asAvailable-for-Sale. The securities Held-for-Trading (HFT) and Available-for-Sale (AFS) areto be marked-to-market periodically. As per the RBI, Trading Book includes HFT and AFSand Banking Book refers to HTM.

Held-to-Maturity

The risks inherent in the HTM portfolio:

Price risk if the acquisition cost is above par. The premium over the par value will beamortized annually till maturity.

Re-investment risk due to reinvestment of high yielding security inflow at lower yields.

Held-for-Trading

Classification as HFT should be an explicit management decision considering theintention, the trading strategies, the risk management capabilities, the capital positionand the manpower skills. Securities classified HFT are to be sold within 90 days(defeasance period). Shifting of securities from HFT to AFS is permitted only underexceptional circumstances such as tight liquidity conditions, extreme volatility orexceptional market conditions. The shifting requires the approval of Board ofDirectors/ALCO/Investment Committee.

Available-for-Sale

These assets in the Trading Book are held for generating profit on differentialinterests/yields. Ideally, the securities held in the Trading Book are marked -to-marketon a daily basis.


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Investment Fluctuation Reserve

This is maintained to guard against any possible reversal of interest rate environment onunexpected developments. It is prudent to transfer maximum amount of gains realizedon sale of securities to the IFR. Banks are free to build IFR up to 10 per cent of theinvestment portfolio under HFT and AFS with the approval of the Board of Directors

Interest rate risk

Management of interest rate risk aims at capturing the risks arising from the maturityand re-pricing mismatches of various rate-sensitive assets and liabilities. The interestrate risk is measured from earnings and economic value perspective.

Earnings perspective involves analyzing the impact of changes in the interest rate onaccrual or reported earnings in the near term, measured by changes in th e Net InterestIncome. Economic Value perspective involves analyzing the changes of impact of intereston the expected cash flows on assets minus the expected cash flows on liabilities plusthe net cash flows on off-balance-sheet items. The level of interest rate changes is animportant factor to choose fixed/floating interest rate assets/liabilities, their maturitiesand hedging decisions.

Interest rate risks in the Trading Book arise due to:

i) The volatility in the interest rate; this will have an impa ct on exercising theembedded options, ii) Different benchmark interest rates not moving up or down bysame basis points, iii) Different currency interest rates not moving up or down by thesame basis points, iv) The impact on the interest costs/yield of debt instruments not beequal due to non-parallel shift in the yield curve, v) A the highly inflationary economy;managing interest rates in such a situation is a big challenge, vi) Competition andbusiness compulsions; the bank may change the interest rates opposite to the generalmarket movement of interest rate.

Middle Office: One of the important organisation structures in Risk Management, it isresponsible for the critical functions of independent market risk monitoring,measurement, analysis and reporting for the bank's ALCO. Middle Office shouldindependently report to ALCO.

Liquidity risk

The liquidity risk in Treasury manifests in different dimensions:

i) Funding Risk: It arises due to replacement of liabilities withdrawn, ii) Time Risk: Itarises due to the need to compensate for non-receipt of expected inflows of funds, thatis, performing assets turning into non-performing assets; and iii) Call Risk: It arises onthe crystallisation of contingent liabilities and the inability to leverage profi tablebusiness opportunities when desirable.

Exchange risk


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Available accounting information do not provide a reliable base to calculate exposureand the actual risk a bank faces, which depends on its future cash flows and theirassociated risk profiles. There is the distinction between the currency in which cashflows are denominated and the that which determines the size of the cash flows. Forexample, a borrower selling jewellery in Europe may keep his records in rupees, invoicein euros, and collect euro cash flow, only to find that its revenue stream behaves as if itwere in US dollars. Trading in the forex market is fraught with `market risks'. With rupeemoving towards full convertibility and the reduced `direct' intervention by the central

bank, USD/INR has increased volatility in the forex market. Rupee, which was firming upfrom the 49/dollar levels (during September 2000) in the past, has started reboundingfrom 43 (July 2005) levels to 46.40 levels (as of December 5) on the back of recovery ofthe dollar globally. Added to this, the dollar gained strength on account of 12 successiveincreases in rates, by 25 bps each from June 2003 (an increase from 1 pct to 4 pct). Theforward market has also been moving in tandem with Spot INR, easing up a bit f or everygain of the rupee against the USD. Six months annualized premier, which was at 2.91 pctin November 2004 was down to 0.27 pct in September 2005. However when the rupeestarted to move south, Forwards too tracked it for the six months forwards to go.

Measurement of interest rate risk

The methods to measure of Interest Rate Risk in trading book are:

i) Duration Gap analysis: Duration is a value and time weighted measure of maturity thatconsiders the timing of all cash inflows from assets and all cash outflows associated withliabilities. It measures the average maturity of a promised stream of future cashpayments. In effect, duration measures the average time needed to recover the fundscommitted to an investment.

ii) Convexity: Convexity is the rate of change of duration. Compared to duration, it is abetter measure of price sensitivity for larger change in interest rates.

iii) Simulations: Simulations are computer-generated scenarios about the future thatpermit banks to analyze interest rate risk and business strategies in a dynamicframework. Given such information, banks may evaluate the desirability of variouscourses of action. The scenarios are based on assumptions, such as changes in interestrates, shape of yield curve, pricing strategies, growth volume and mix of assets andliabilities and hedging strategies.

iv) VaR based methodology: VaR is an estimate of potential loss in a position or

asset/liability or portfolio of assets/liabilities over a given holding period at a givenlevel of certainty.

The Bank of International Settlements has accepted VaR as a measurement of marketrisks and provision for capital adequacy for market risks.

VaR is used as a MIS tool in the trading portfolio to "slice and dice" risk bylevels/products/geographic/level of organization etc.


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Stress Testing

Stress testing is the topic of the day. Recently leading US banks underwent stress testingunder the Supervisory Capital Assessment Program conducted by the Board of Governorsof Federal Reserve System in the United States of America.

A banking organization holds capital to guard against uncertainty. Capital reassures aninstitutions depositors, creditors and counterparties--and the institution itself--that anevent such as an unexpected surge in losses or an unanticipated deterioration inearnings will not impair its ability to engage in lending to creditworthy borrowers andprotect the savings of its depositors.

The assessment and monitoring of strengths and vulnerabilities of financial systems iscalled macro prudential analysis. Macro prudential analysis uses quantitative informationon the financial system as well as qualitative information on the institutional andregulatory frame work.

It encompasses surveillance of financial market conditions and analysis of macrofinancial linkages. It is in turn part of a broader framework of macroeconomicvulnerability assessment, which includes the balance sheet approach, debt sustainabilityanalysis and monitoring of macroeconomic conditions.

One of the key techniques for quantifying financial sector vulnerabilities is stresstesting. The term stress testing refers to a range of statistical techniques used to helpassess the vulnerability of a financial system to exceptional but plausible events.

System-wide stress tests (or macro financial stress tests) measure the impact of shockson financial system stability.

Compared to stress tests for individual financial institutions, the system -wide stresstests haveas the name suggestswider coverage (i.e. the financial system or asystemically important part of it), are used for a different purpose (financial sect orsurveillance rather than risk management), focus more on channels of contagion (i.e.how a risk to one institution can become a systemic risk), and often have to use more

streamlined techniques (because of the ensuing complexity of the calculations).

Also, system-wide stress testing is a much newer concept, and the literature on thetopic is consequently much shorter than that on stress testing for individual institutions.

Stress tests can be classified, by methodology, into three main types: (i) sensit ivityanalysis, which seeks to identify how portfolios respond to changes in relevant economicvariables (such as interest rates and exchange rates); (ii) scenario analysis, which seeksto assess the resilience of financial institutions and the financial system to an


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exceptional but plausible scenario; and (iii) contagion analysis, which seeks to takeaccount of the transmission of shocks from individual exposures to the financial systemas a whole.

The importance of stress testing for macro prudential analysis derives from integrating aforward looking macroeconomic perspective, a focus on the financial system as a whole,and a uniform approach to the assessment of risk exposures across banks.

Unlike the stress tests conducted at large banks, which are designed to measureportfolio- and bank-specific risk exposures, system wide stress tests apply a common setof scenarios based on an assessment of macroeconomic and market risks. This uniformapproach allows for the aggregation of results, helping to identif y key vulnerabilities atthe level of the overall system, and providing comparable information on risk profilesacross banks.

Stress testing is primarily about identifying latent exposures. There is little need toperform complicated stress test calculations if the exposures are obvious, or obviouslylacking. Stress tests are needed to identify exposures that are less obvious, perhapshidden across a wide variety of instruments, credits, and derivatives positions.

System-wide stress testing can be viewed as a multi-step process of examining the keyvulnerabilities in the system. This involves: identifying the major risks and exposures inthe system and formulating questions about those risks and exposures; defining thecoverage and identifying the data required and available; calibrating the scenarios orshocks to be applied to the data; selecting and implementing the methodology; andinterpreting the results.

To be relevant, stress tests must probe the consequences of potential shocks that arerelated to the macroeconomic risks that exist in the actual situation of the country. Theprocess of designing system-wide stress tests therefore typically starts with a discussionof the potential risks faced by the economy. The discussion then suggests that certain

types of shocks (e.g. a potential increase in interest rates or a depreciation of thecurrency) are more likely in the given economy than other types of shocks.

The fact that there are macroeconomic risks that could result in shocks to the financialsystem does not necessarily mean that the impact of the shocks would be large. Theimpact can still be small if the exposures in the system are small. It is the purpose of thestress tests to assess how the risks combine with the exposures. The design of stresstests is often an iterative process, since some originally identified risks may lead torelatively small impacts, while some risks originally assessed as small may lead to largeimpacts if there are substantial exposures.

Even if the exposures are large and stress tests identify a potentially large impact on the

financial system, it is the purpose of the other parts of the macro prudential analysis toassess the likelihood that these impacts can be mitigated by prompt action bysupervisors and banks.

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 ofstatistical models, stress tests are a relevant and integral part of banks' risk


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management frameworks. Further, the supervisory review process under Pillar 2 of BaselII framework is intended not only to ensure that banks have adequate capital to supportall the risks in their business, but also to encourage banks to develop and use better riskmanagement techniques in monitoring and managing their risks.

In the above background, the need for banks in India to adopt stress tests as a riskmanagement 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 havebeen suitably revised. Guidelines on stress testing, as relevant for the Basel IIframework, will be issued separately.

Reserve Bank of India in notification dated 26th June 2007 has asked banks to put inplace a Board approved Stress Testing framework to suit their individual requirementswhich would integrate into their risk management systems. Banks need to put in p laceappropriate stress test policies and the relevant stress test framework for the variousrisk factors by September 30, 2007.

As banks may need to undertake the stress tests on a trial basis and use the results ofthese trial tests as a feedback to further refine the framework, RBI has decided that

banks be allowed some time to refine the stress testing frameworks. Banks are requiredby RBI to ensure that their formal stress testing frameworks, which are in accordancewith the guidelines, are operational from March 31, 2008.

Stress testing guidelines and mechanism

1.Introduction1.1. Banks are undertaking increasingly complex financial operations (both in credit,

trading and other related services), which are exposing them to several risks. Bankcredit has always been a dynamic instrument of growth in India even post economicliberalization. Establishing and strengthening enterprise -wide Risk ManagementSystem and Capital allocation within a bank is getting more important as theregulatory requirements are moving towards economic-based measures of risk.Banks are urged to build sound internal measures of credit, operational and marketrisks for all their activities.

1.2. Internationally, banks are increasingly relying on statistical models to measure andmanage the financial risks to which they are exposed. These models are gainingcredibility because they provide a framework for identifying, measuring,communicating and managing risks. Stress Tests are resorted to, as the existingmodels cannot incorporate all possible risk outcomes arising out of sudden anddramatic changes.


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1.3. Globally, stress testing has become an integral part of banks risk managementsystems and is used to evaluate the potential vulnerability to some unlikely butplausible events or movements in financial variables. Stress testing typically refersto shifting the values of individual parameters that affect the financial position ofa firm and determining the effect on the firms business. It is an estimation ofpotential economic losses in the portfolio by subjecting the same to an abnormalmarket scenario. Ideally, stress testing can and should be applied to the entirerange of risks that an organization runs. However, stress testing of credit portfolio

and for liquidity funding is becoming more developed, but stress testing foroperational risk and aggregation across risk elements is at an early stage ofdevelopment.

1.4. 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 ofstatistical models, stress tests are a relevant and integral part of banks' riskmanagement frameworks. Further, the supervisory review process under Pillar 2 ofBasel II framework is intended not only to ensure that banks have adequate capitalto support all the risks in their business, but also to encourage banks to developand use better risk management techniques in monitoring and managing their risks.

1.5. With a view to improve risk management practices in banks, Reserve Bank of India(RBI) has issued guidance notes on Asset Liability Management, Management ofCredit Risk, Market Risk and Operational Risk since 1999. Further, theannouncement of New Capital Adequacy Framework (NCAF) in India has broughtthe risk management capabilities of banks into greater focus. In its annual policystatement for 2006-07, RBI has emphasized the need for Banks in India to adoptStress Tests as a risk management tool. In general, RBIs stance has always beenone of gradual convergence with international best standards with suitably countryspecific adaptations.

1.6. In June 2007, RBI has issued guidelines on Stress Testing and advised banks to putin place board approved Stress Testing Policy and relevant stress test frameworkfor various risk factors. Till such time, banks are to undertake the stress tests ontrial basis and use the results of these tests to further refine the framework.However, banks should ensure that their formal stress testing frameworks areoperational from March 31, 2008.

1.7. This Stress Testing Policy should cover the aspects like, a) frequency and procedurefor identifying the principal risk factors which affect the banks portfolio andshould be stressed; b) methodology for constructing appropr iate and plausiblesingle factor and multi factor stress tests; c) procedure for setting the stresstolerance limits; d) process for monitoring the stress loss limits; e) remedial

actions required to be taken at the relevant stages; f) authorities designated toactivate the remedial actions; g) need for identification of the responsibilitiesassigned to various levels/functional units; h) need for specification of reportinglines.

1.8. Types of Stress testing: There are broadly two categories of stress tests used inBanks viz. Sensitivity tests and Scenario tests. These may be used eitherindependently or in conjunction with each other.


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1.8.1.Sensitivity Tests are normally used to assess the impact of change in onevariable (for example, a high magnitude parallel shift in the yield curve, asignificant movement in the Foreign Exchange rates, a large movement in theequity index etc) on the banks financial position.

1.8.2.Scenario Tests include simultaneous moves in a number of variablesbased ona single event experienced in the past (historical scenario) or a plausiblemarket event, which has not yet occurred, and the assessment of their

probable impact on the Banks financial position. Scenario analysis measuresthe combined effect of adverse movements in more than one risk factor. E.g.domestic economic downturn, tightening of market liquidity, increase in creditrisk downgrades, repricing, basis, yield curve risk or option risk.

2. Objectives:

This Stress Testing Policy aims to:

2.1. Supplement banks risk management system and help in making thesesystems more robust.

2.2. Enable the bank to be better equipped to meet the stress situations as andwhen they arise and overcome them as well.

2.3. Assess the potential impact of stress situations on the banks earnings andCapital position and also to develop appropriate strategies for mitigatingand managing the impact of those situations.

2.4. Perform the dual role of being a diagnostic tool for improving the banksunderstanding of its risk profile and for introducing forward lookingelement in the Capital Assessment process.

2.5. To hold capital buffer that would be aligned to the exceptional butplausible stress situations.

2.6. Serve as an important component of banks Interna l Capital AdequacyAssessment process (ICAAP) under Basel II.

2.7. Build additional reserves as cushion to meet the depreciation losses due tostress events and add strength to Balance Sheet.

3. Frequency & Procedure for identifying the principal risk factor s to bestressed:


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3.1. The competent authority for identifying the principal risk factors to bestressed would be Credit Risk Management Committee (CRMC) for CreditRisk, Asset Liability Committee (ALCO) for Market Risk and Operational RiskManagement Committee (ORMC) for Operational Risk. The frequency foridentifying the principal risk factors would be annual. The CRMC, ORMC andALCO shall be responsible for:

3.1.1.Identifying the principal risk factors which affect the banksportfolio and should be stressed;

3.1.2.Approving the methodology for constructing appropriate andplausible single factor and multi factor stress tests.

3.1.3.Approving the underlying assumptions and the level of stress to beapplied;

3.1.4.Setting the stress tolerance limits;3.1.5.Reviewing the stress test results and monitoring the stress loss

limits;

3.1.6.Put in place appropriate contingency plans for meeting thesituations that may arise under adverse circumstances and toactivate necessary remedial measures to counter any suchsituation/s;

3.1.7.Allocating capital for various risks;3.1.8.Periodically communicating the stress test results and the actions

taken, if any to the Board;

3.1.9.Reviewing the need to modify the stress testing framework withreference to certain elements like the risk factors, stress scenarios,levels of stress to be applied, the underlying assumptions, stresstolerance levels, remedial actions etc,; and

3.1.10. Designing an appropriate MIS to support the stress tests to beconducted; and ensuring an appropriate and effective internalcontrol mechanism to validate the stress tests and their findings.

3.2. The Supervisory Committee of Directors on Risk Management and ALM /Board of Directors shall regularly review the results of scenario analysis andstress tests, including the major assumptions that underpin them.

4. Methodology for conducting appropriate stress tests:

4.1. Bank will conduct stress tests / scenario analysis at quarterly intervals toinclude the following risks:

Liquidity Risk:


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4.1.1.Deposit run-offs in a bank specific event4.1.2.Deposit run-offs in a market specific event Interest Rate Risk:

4.1.3.Unfavourable differential changes in key interest rates 4.1.4 Impact on the trading book due to event based stress scenarios

such as policy changes and subsequent impact on bond / equitymarket.

Credit Risk:

4.1.4. Economic downturn Downgrade for different rating grades4.1.5. Changes in provisioning requirement for various asset categories

Foreign Exchange Risk:

4.1.6. Adverse movement in exchange rates

4.2 Since Operational Risk is still at a nascent stage of development stress testswill be conducted once data on operational risk areas is available.

4.3 Stress scenarios shall be designed on the basis of either historical events orhypothetical events. Bank shall carry stress test based on the relevantparameters at three levels of increasing the adversity Minor, Medium andMajor, with reference to Normal situation and estimate the financialresources needed by it under each of the circumstances to:4.3.1 meet the risk as it arises and for mitigating the impact of

manifestation of that risk,4.3.2 meet the liabilities as they fall due, and4.3.3

meet the minimum CRAR requirements.

5. Frequency of Stress Testing:5.1 Bank shall conduct stress tests on the various risks at quarterly intervals.

However, Bank shall apply stress at varying frequencies as warranted bythe respective business requirements, relevance and costs. For e.g. Dailyor weekly for trading book items or for various market risks and quarterlyfor less volatile items like credit risk in loans or HTM securities, interest

rate risk in the banking book etc. 5.2 Bank shall conduct stress test on ad-hoc basis as may be warranted when

there are any special circumstances for example, a rapidly deterioratingpolitical / economic conditions in a country may warrant a quickassessment of the likely impact on the bank on account of its exposures tothat country.

6. Procedure for setting and monitoring the stress tolerance limits:


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6.1 Stress tolerance limits may be fixed after comparing the trend of stressresults for at least 8 quarters.

6.2 Once the stress tolerance limits are fixed, the stress test results should becompared with the limits and immediate corrective remedial action shouldbe initiated in case of breach in limits.

6.3 The respective functional departments viz. Resource Mobilisation,Treasury, Corporate Credit and SME etc should initiate necessary correctiveaction.

7. Reporting Framework:7.1. Stress Testing on various risks shall be done at periodic intervals by the

Risk Management Department and reported to CRMC/ ORMC/ ALCO forCredit, Operational and Market Risk respectively. Notes placed to CRMC ,ORMC and ALCO indicating the assumptions, results and outcome of thestress testing exercise shall be placed before the Supervisory Committee ofDirectors on Risk Management / ALM for information and directions.

8. Documenting Stress Testing8.1. Bank shall document the stress tests undertaken, the underlying

assumptions, the results and the outcomes. The Bank shall preserve thedocumentation at least for a period of 5 years. The bank shall makeavailable for verification by the Supervisor/ Auditors on the various stresstests carried out.

9. Policy Review9.1.This Stress testing Policy shall be reviewed on annual basis taking into

account the assumptions underlying the stress test conducted earlier, forfurther refinement. These periodic reviews shall be necessary to ensure theintegrity, accuracy, and reasonableness of the stress -testing framework. Thereviews will cover:9.1.1.Adequacy of documentation9.1.2.Integration of the stress testing framework in the day-to-day risk

management processes9.1.3.Scope of coverage of the framework and the levels of stress applied9.1.4.Integrity of MIS and data feeding into the stress tests and9.1.5.Adequacy of remedial action and efficiency of the systems for their

activation.9.2. In emergency situations, Chairman and Managing Director or in his

absence, Executive Director shall be the competent authority to revise and/ or amend this policy based on recommendations of CRMC/ORMC/ALCOand subject to ratification by the Supervisory Committee of Directors onRisk Management and ALM in its next meeting thereafter.


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Stress Tests: Testing Financial Health

The current financial crisis has underscored the importance of detailed knowledge aboutthe vulnerabilities of the financial sector, especially the banks. One of the tools that

helps to gauge how well a bank's balance sheet and financials can weather a var iety of

shocks is stress testing. Although stress tests were originally developed for use with

trading portfolios, they have now become a widely used risk management tool. These

tests alert the bank management to adverse and unexpected outcomes related to a

variety of risks and provide an indication of how much capital might be needed to absorb

losses, should large shocks occur.

The stress test is generally used to monitor the functioning of the heart and vascular

system of a human being when he exercises. This test helps answer two generalquestions: 1) Does the person have Coronary Artery Disease (CAD), which only becomesapparent when the heart is stressed out by exercise? 2) If there is an underlying heartdisease, how severe is it likely to be? To test the condition of the heart, the patienteither walks on a treadmill or is given an intravenous medication that simulates theexercise while being connected to an Electrocardiogram (ECG) machine, usually with thestandard 10 connections used to record a 12 -lead ECG. The level of exercise is increasedin three-minute stages of progressively increased grade (% incline) and speed (mph,km/h, etc.). The patient's symptoms and blood pressure responses are repeatedlychecked.

Based on a similar concept, a stress test of banks' and financial institutions' balancesheet is an evaluation of a bank's financial position under a severe but possible scenarioto assist in decision making within the bank. Further, stress testing alerts bankmanagement to adverse unexpected outcomes related to a variety of risks and providesan indication of how much capital might be needed to absorb losses, should large shocksoccur. By itself, stress testing cannot address all risk management weaknesses, but aspart of a comprehensive approach, it has a major role to play in strengthening bankcorporate governance and the resilience of individual banks and the financial system.

`Stress testing' has been adopted as a generic term describing various techniques usedby financial firms to gauge their potential vulnerability to exceptional, but plausible,events. The most common of these techniques involve:

y To determine the impact of a particular strategy on the portfolio of a firm orbusiness unit in a particular market risk factor (a simple sensitivity test) or of a

simultaneous strategy in a number of risk factors, reflecting an event which the

firm's risk managers believe may occur in the foreseeable future (scenario

analysis). The scenarios are developed, either by drawing on significant market

events experienced in the past (historical scenarios), or by visualizing the


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consequences of a plausible market event which has not yet happened

(hypothetical scenarios).

y Other techniques used by some firms to capture their exposure to extrememarket events include a maximum loss approach, in which risk managers estimate

the combination of market moves that would be most damaging to a portfolio,

and extreme value theory, which is the statistical theory concerned with the

behavior of the `tails' of a distribution of market returns.

y Stress testing process includes setting stress testing objectives, definingscenarios, discussing the results of stress tests, assessing potential actions and

decision making.

Stress tests enable managers to track a firm's exposure to price changes during eventsthat are considered reasonable. This, in turn, allows senior management and businessunit heads to determine whether the firm's exposures correspond to its risk appetite.Because of their intuitive appeal, stress te sts are thought to facilitate the dialoguebetween risk managers, senior managers and business unit heads about the risks takenby the firms and methods for monitoring and managing those risks. From the stress testsprocess, the decisions regarding the lim its to be set on proprietary position taking,

capital charges on traders and trading units and the appropriateness of the riskmanagers' modeling assumptions can be taken. It should be emphasized that stress testsare typically only one element of the process through which a financial firm develops itsquantitative and qualitative risk management policies.

The depth and duration of the current financial crisis has led many banks andsupervisory authorities to question whether stress testing practices were sufficient priorto the crisis and whether they were adequate to cope with rapidly changingcircumstances. Involvement of the boards and senior management is critical in ensuringthe appropriate use of stress testing in banks' risk governance and capital p lanning.

In the present scenario, where many of the big banks in the US have been highly exposedto the financial crisis, senior managements of these banks, as a whole, have taken anactive interest in the development and operation of stress testing, with the results ofstress tests serving as inputs for strategic decision- making, which has benefitted thebanks. (Refer Table 1)


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flaws with relying solely on such an approach. In a recent paper, the Bank forInternational Settlements (BIS), has listed the key principles that banks must follow todesign more foolproof stress tests. This would involve four possibilities:

1. Simulating shocks which we suspect are more likely to occur than what historicalobservations suggest.

2. Simulating shocks that have never occurred.

3. Simulating shocks that reflect the possibility that statistical patterns could breakdown in some circumstances, and

4. Simulating shocks that reflect some kind of structural breakdown that could occur inthe future.

To begin with, stress testing should form an integral part of the overall governance andrisk management culture of the bank. Stress testing should be actionable, with theresults from stress testing impacting decision making at the appropriate managementlevel, including strategic business decisions of the board and senior management. Boardand senior management involvement in the stress testing program is essential for itseffective operation. Senior management should be able to identify and clearly articulatethe bank's risk appetite and understand the impact of stress events on the risk profile ofthe bank. Senior management must participate in the review and identification ofpotential stress scenarios, as well as contribute to risk mitigation strategies. A bankshould operate a stress testing program that:

y Promotes risk identification and control.y Provides a complementary risk perspective to other risk management tools.y Improves capital and liquidity management, andy Enhances internal and external communication.

Stress tests must play an important role in the communication of information about riskwithin the bank. In contrast to purely statistical models, plausible forward-lookingscenarios are more easily grasped and assist in analyzing the vulnerabilities andevaluating the feasibility and effectiveness of potential counteractions.

Stress testing programs must take account of views from across the organization andshould cover a range of perspectives and techniques. Banks must use multipleperspectives and a range of techniques in order to achieve comprehensive coverage intheir stress testing programs. These include quantitative and qualitative tec hniques tosupport and complement the use of models and to extend stress testing to areas, whereeffective risk management requires greater use of judgment.

Banks must document the assumptions and fundamental elements for each stress testingexercise. These include: the reasoning and judgments underlying the chosen scenariosand the sensitivity of stress testing results to the range and severity of the scenarios. Anevaluation of such fundamental assumptions must be performed regularly or in the lightof changing external conditions and their outcome documented.

Most importantly, banks must regularly maintain and update their stress testingframework. The effectiveness of the stress testing program, as well as the robustness of


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major individual components, should be assessed regularly and independently. In thefinal analysis, the effectiveness and robustness of stress tests should be assessedqualitatively, as well as quantitatively, as models can never quite substitute for humanjudgment.

Approach towards Stress Testing Exercises

Before designing any stress test approach, the first thing we want to know is the goal of

the test. In other words, what questions should the test answer? Some questions mightinclude the following:

y What would be the loss if the oil price would shoot up to $100 per barrel?y What would happen if inflation shoots up by 300 bps?y What would happen if the deposit rate raise by 300 bps?y What would happen to our risk level if we went into a deep recession?y Would the recession affect us immediately, or would there be a delay?y How do differences in local economies affect our risk?y What would happen to our risk level if interest rates went up significantly?y What impact do new accounts have on our portfolio risk level?y If we were to enter a major recession, could we mitigate its impact by focusing

on specific geographies? Would it be better to loosen lending policies in some

areas while tightening them in others?

y What would be the effect of a significant increase in area property valu es?y What would happen in the event of a significant shift in the industry composition

of our portfolio?

y Is our small business portfolio more risk sensitive to changes in the economy thanour middle-market accounts?

y How does the economy affect our large customers? Which industries are moresensitive?

After identifying the relevant shocks (as mentioned above, e.g., demand shock, oil priceincrease, etc.), these have to be translated into consistent macro scenarios with thehelp of a macro engine. This macro engine could be the macroeconometric model, a VARmodel, or simple historical correlations could be imposed. In the next step, variouscredit risk models are used to calculate the impact of the macro scenarios on thefinancial sector. In the last step, loss measures are identified and estimated (credi tlosses/capital), which are suitable for evaluating the impact of shock from a financialstability point of view.

Stress Test Results

The final question that we seek to answer is to what extent each shock would underminethe capital position of the banking industry. The loss measure is defined as follows:

(ELshock - ELbase) / Capital


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Where EL is the `median' of the cumulated loss distribution. In the case of credit risk,two basic risk measures are used: Expected and unexpected losses. The former is t hemedian or mean of losses and is supposed to be covered by provisioning. The unexpectedlosses are to be backed by capital. The expected losses are taken in the baselinescenario. As to the shocks, the expected losses conditional on the extreme realizati on ofthe risk drivers are calculated. In the baseline scenario, we assume that banks alwaysprovision enough to make up expected losses (they have enough profit, on the one hand,and follow prudent provisioning on the other). Thus, to calculate the impact of the

shock, the difference between the EL in the shocked and the baseline scenario is taken.These extra losses caused by the shock should be covered by capital.

The stress test results may reveal that the banking sector is robust and resilient to therelevant shocks. Even a sharp decline in real GDP or an increase in foreign rates would,at the most, cause an approximately 10% loss of capital and is within the prudentiallimit.

Stress testing is introduced in India recently but the same has been introduced longbank in the international market.

To explain that below mentioned is the case of Stress Testing in Nigerian Banks

WHAT IS STRESS TESTING?

Since the start of the global financial crisis, stress testing has received increasedattention by regulators, rating agents, bank management, etc. Stress testing isnot new. It has been a very important tool in the arsenal of risk management formany years. However, banks have not been very successful in implementingeffective stress testing systems in the past. The reasons for this are lack of data,complexity and quantitative models capability required and inability tointegrate the results of stress testing with the risk management decision process.

Stress testing is the process of:

a. Defining potential extreme adverse future economic scenarios,

b. Measuring the sensitivity of the bank's credit, market, investment andoperational risk portfolios to changes in economic variables resulted underextreme scenarios defined


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c. Aggregating the results of b and quantifying the overall negative impacton planned profitability, capital levels, liquidity position, etc.

d. Comparing the results of c to board approved risk appetite levels andimplementing risk reduction business strategies, policy changes, etc.should the results of the stress test exceed risk appetite.

Step d is the most important in implementing an effective stress testingframework. During the current global financial crisis, many international banksran into trouble because their stress testing frameworks omitted this importantstep. Senior management failed to adjust their risk taking strategies and riskmanagement policies based on the stress testing results and continue to dobusiness as usual in the hope that the stress scenario will never realize. As wenow know, extreme scenarios have a habit of occurring more frequently thanpopular belief, causing these banks to be bailed out to survive.

CHALLENGES IN IMPLEMENTING STRESS TESTING

The first and foremost challenge in implementing stress testing is the lack ofhistorical data to measure the impact of extreme stress events. As Nigeria has notyet implemented global risk management standards, such as Basel II, whichrequires banks to maintain elaborate loss histories, dat a availability for derivingstress test impacts is limited. However, using appropriate statistical calibrationtechniques and loss data from other emerging markets, this problem can beovercome to derive plausible stress testing impacts for the Nigerianenvironment.

A second pre-requisite for a successful stress testing programme, is to haveboard level approved risk appetite limits. These limits will drive the actionsrequired to reduce risks where the results of stress testing indicate excess risks.Without such limits, no action will be taken.

To limit the negative potential future impact of stress scenarios, tough decisions,sometimes with immediate negative revenue implications are required. Seniormanagement needs to take a strategic view and be prepared to position thebank for long term sustainability and growth, sometimes at the expense of shortterm revenue targets, if stress testing is to be effective.


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TYPES OF STRESS TESTING

Nigerian banks should perform 3 types of stress testing as part of their on-goingstress testing framework execution. These are:

Moderate PBT stress.

This refers to the negative impact on planned PBT levels, due to moderatestress scenarios mild recession.

Liquidity stress testThis refers to the negative impact on liquidity levels, should extremeliquidity events occur large deposits outflows that cannot be replaced,significant reduction in counterparty credit lines, etc.

Capital stress test

This refers to the impact on projected capital levels, should extremescenarios realize and large losses are incurred, eating into capital.

It is important that stress testing be performed bottom up ie taking intoaccount the specific risk characteristics of loan portfolios, investments, collateralholdings, business processes, etc. Top down stress testing with simplifyingassumptions about risks will lead to stress test results that are insufficiently

robust. Results of these stress tests should be used to adjust risk policies andbusiness strategies.

NIGERIAN CENTRAL BANK ROLE IN STRESS TESTING

One of the most severe early consequences of the global melt down after thecollapse of Lehman Brothers in September 2008, was a freeze up of the interBank markets worldwide, as confidence became impaired. Frozen inter -bankLending only started to thaw recently when regulators, lead by the US FederalReserve, implemented bank recapitalization based on the published results ofStress testing.

A transparent system of standardized stress testing, lead by a central bank canthus greatly restore and maintain confidence in country's banking system. Onelasting consequence of the global financial crisis will be an ongoing focus onsystemic stability i.e. the robustness of the banking system to withstand severeshocks. Stress testing has thus come to stay and the Nigerian banking industryshould start to incorporate stress testing as a crucial building block of the riskmanagement architecture.


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Conclusions

I believe that the periodic application of stress-test scenarios must bean integral part of a banks risk and management culture because they canprovide potential risk exposure assessments and support the capital planning

and the defining of alternative liquidity plans.

They can increase the endurance of banks and of the fina ncial systemwhen faced with financial crises especially during stability/economic growthperiods, when, due to the lack of important risks, banks may not be aware of themajor impact crisis may have upon their financial stability and may accepthigher risks exposures more easily and with lower prices.

The importance of the stress-test was revealed by the amplitude andduration of the ongoing financial crisis; in the same time, the need of improvingtheir effectiveness is driven by the fact that the crisis has overall proven to be

much more severe in terms of amplitude than the worst scenarios of many crisissimulation systems.


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BIBLIOGRAPHY

http://www.rbi.org.in/home.aspx

www.thehindubusinessline.com/mentor/2005/12/26/stories/2005122601691000.htm

http://www.fisglobal.com/EMEA/BankingProducts/WholesaleBanking/TreasuryDealingRoomSystem/index.

htm

http://www.researchandmarkets.com/reports/c 27974

http://www.indianbank.in/winser/image_newsletter.htm

Documents

Stress Testing project