Basel Committee addresses stress testing

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BASEL - The Basel Committee on Banking Supervision has released a consultative paper assessing weaknesses in stress testing exposed by the unfolding financial crisis.

The Bank for International Settlements paper, 'Principles for sound stress-testing practices and supervision', focuses on the underestimation of the potential severity and duration of stress events and inadequate enterprise-wide risk identification and aggregation. Expectations are also set for supervisors - emphasising responsibilities to review stress-testing practices and ensure sound programmes are put in place.

The paper says effective stress testing should be directed from the board and senior management level, provide forward-looking risk assessments and be used to compliment the information afforded by models and historical data.

The Basel Committee highlights a need for stress testing to form an integral part of capital allocation and liquidity contingency planning. Connected to this, stress testing should guide a bank's risk tolerance and facilitate the development of risk mitigation or contingency plans across a range of stress scenarios.

"Stress testing is an important risk management tool," says Nout Wellink, chairman of the Basel Committee and president of the Netherlands Bank. "It plays a critical role in strengthening not only bank corporate governance but also the resilience of individual banks and the financial system."

Wellink says the financial crisis has demonstrated the importance of stress testing as an integral part of any bank's risk management, liquidity and capital planning.

The consultative paper can be downloaded here.