Basel releases stress-testing guidance

The Basel Committee on Banking Supervision last month released formal guidance for banks and regulators on stress testing, believing it has a key role to play in supporting corporate governance and ensuring the resilience of individual firms and the financial system.

In the consultative document, Principles for sound stress testing practices and supervision, the committee suggests losses taken by banks during the financial crisis may have been exacerbated by inadequate stress-testing policies.

"Basel II requires that banks subject their credit portfolios in the banking book to stress tests. Recent analysis has shown that implementation of this requirement would not have produced large loss numbers in relation to banks' capital buffers going into the crisis or their actual loss experience," the committee said.

For stress testing to be effective, boards of directors and senior management need to explicitly set objectives for the stress-test programme, define scenarios, discuss the results and assess potential actions that should be taken. That would mean an overhaul of practices at institutions that have performed stress tests as an isolated exercise within the risk function, with minimal involvement from business lines.

Changing conditions

The committee said more testing is needed on the effects of changing market conditions, while firm-wide stress tests could help identify correlated tail exposures and risk concentrations, covering on- and off-balance-sheet assets and contingent and non-contingent liabilities. To facilitate this, experts from across different business lines should be involved in the discussions, while further investment in IT systems may be required, the committee added.

An effective stress-test programme should be used in the risk management of individual transactions, portfolios, to adjust business strategy, and to challenge the projected risk characteristics of new products where little historical data is available. Tests should range from straightforward sensitivity analysis based on single risk factors, to complex tests that examine interactions between systemic risk drivers and asset valuations.

The guidance does not prescribe specific scenarios, but says they should be forward-looking and take into account system-wide relationships - for instance, how a bank's business may be affected by the decisions made by other institutions. One particular criticism of some banks is that the scenarios they used were not extreme enough. The committee says reverse stress tests, which look at scenarios that could threaten the viability of an institution, are particularly beneficial. By assessing possible factors that could cause failure, banks can analyse whether they could amend their business in some way to avoid such an eventuality.

Recent experience has highlighted how funding and asset markets become highly correlated during stress periods. Consequently, scenarios should include price shocks for certain assets, the drying up of liquidity, the possibility of losses and how that would damage a firm's financial strength. At a time when counterparty risk has assumed critical importance, the committee says banks should look closely at their exposures to highly leveraged counterparties such as hedge funds and financial guarantors when considering their own vulnerability to certain asset classes.

National supervisors, meanwhile, are urged to be proactive and force banks to take corrective action if there are material deficiencies in their stress-test programmes. Supervisors are also encouraged to challenge the scope and severity of scenarios used - and could prescribe specific scenarios under which banks' viability is threatened.

Furthermore, stress-test results should play an integral role in supervisory reviews of banks' capital adequacy. If supervisors come to the conclusion that banks' capital might not be freely transferable during downturns, or that their ability to raise funds at a reasonable cost is impaired, they could require firms to increase their level of capital above minimum Pillar I requirements.

Rob Davies.

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