The Bank for International Settlements (BIS) has issued a list of improvements to stress-testing practices that it says could help banks and regulators avoid a repeat of the failures exposed during the financial crisis.
The document is the latest in a series issued by the Basel Committee on Banking Supervision intended to address various weaknesses in the financial sector. Stress tests performed by banks before and during the crisis were not severe enough, the Committee said, and in any case the results were often ignored by senior management and everyone else outside the risk management office.
The Committee sees stress testing as an essential part of risk management, as it provides a way of dealing with areas such as tail risk that cannot be adequately assessed by other means. The Committee's decision to focus on stress tests was first reported by Risk News in September.
In future, the Committee said, the use of stress tests in risk management should involve board members and senior management, and should be properly documented and regularly reviewed. Firms should use broad stress scenarios that affect the whole bank, and should also employ 'reverse stress tests' in which events that could threaten the survival of the bank are described.
Banks should also correct their failure to model the drop in market liquidity and funding availability in a stress scenario, the Committee added. Institutions should put more effort into modelling complex structured products rather than assuming they would behave similarly to cash bonds with the same credit rating - an assumption shown to have been flawed by the events of 2007-8.
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