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Stress Testing
In markets with increasing volatility and an ever changing economic environment which impacts financial systems, the banks need a way to quantify the extent of these impacts; stress testing provides that way. Stress Testing is a name given to a wide range of quantitative techniques which are employed by the banks to test the vulnerabilities of their financial systems. The idea is to apply shocks of various degrees on different portfolios and instruments and gauge their affect on the bank’s capital base. Stress Testing is also a regulatory requirement for most regulators. For example, the State Bank of Pakistan has issued its own framework for stress testing in the circular titled “Guidelines to Stress Testing” and requires the banks to submit a stress test report on a semi- annual basis.
There are three prominent stress testing techniques:
a. Simple Sensitivity Analysis
In this type of testing a shock is applied to an independent variable and its impact is assessed independently. There is no consideration for any underlying relationship which may exist between the tested variable and other variables in the system.
b. Scenario Analysis
In this type of testing a shock is applied to a variable and its impact assessed on all other dependent variables and the system as a whole.
c. Extreme Value/Maximum Shock
In this type of testing the level of shock which is applied is so high that it eliminates the capital base completely.
Of the three techniques mentioned above, the Simple Sensitivity Analysis is the one required by the State Bank of Pakistan and it is the technique which we shall review for the remaining article.
Focus Areas & Shocks
The regulatory stress testing focuses on the areas of interest rate, non performing loans, stock prices, foreign exchange rate and liquidity risk. Each area is a subjected to minor, moderate and major level shocks. Then the impact of the revised numbers is assessed on the eligible capital, risk weighted assets and the capital adequacy ratio.
I. Interest Rate Risk
This risk relates to the risk that the balance sheet positions may adversely be affected if there is a change in interested rates. The steps used to compute interest rate risk are:
1. Calculate the Mark to Market value for all the rate sensitive assets and liabilities.
2. Calculate the duration for each asset and liability of the on-balance sheet portfolio.
3. Calculate the aggregate weighted average duration of assets and liabilities.
4. Calculate the duration GAP by subtracting aggregate duration of liabilities from that of assets.
5. Calculate the market value of equity for a 1%, 2% and 5% point rise in interest rates.
6. Adjust for tax loss and compute revised figures for risk weighted assets, capital and capital adequacy ratio.
II. Exchange Rate Risk
This risk relates to the risk that the value of equity will be adversely affected in case of a movement in exchange rates. The steps used to assess the exchange rate risk are:
1. Calculate the FX net open position in each currency.
2. Sum all the net long and short positions and ascertain the net exposure.
3. Apply the shock to the net exposure and adjust for tax loss.
4. Compute revised figures for risk weighted assets, capital and capital adequacy ratio.
III. Equity Price Risk
This risk relates to the risk that equity portfolio will be adversely affected in case of a fall in the stock market index. The steps used to compute equity price risk are:
1. Calculate the total mark to market exposure in the stock market.
2. Apply the shock to total exposure and adjust for tax loss.
3. Compute revised figures for risk weighted assets, capital and capital adequacy ratio.
IV. Non Performing Loans
This risk relates to the risk that the non performing loans of the bank will increase and impact the capital numbers adversely. There are two ways to address the non performing loan risk. The first is by increasing the non performing loans and the second is by shifting the categories (i.e. substandard, doubtful and loss) of the non performing loans downwards.
The steps used for stress testing an increase in non performing loans are:
1. Sum all the non performing loans.
2. Apply the shock and increase provisions to match the amount post shock.
3. Adjust for tax loss and compute revised figures for risk weighted assets, capital and capital adequacy ratio.
The steps used for stress testing a downward shift in non performing loans category are:
1. Sum all the non performing loans as per their categories of substandard, doubtful and loss.
2. Shift amounts of each category downward by a fixed percentage and apply the predetermined weight for each category.
3. Adjust for tax loss and compute revised figures for risk weighted assets, capital and capital adequacy ratio.
V. Liquidity Risk
This risk relates to the risk that how adversely the bank will be impacted in case of a fall in liquid liabilities. The steps used to assess this type of risk are:
1. Identify liquid assets and liabilities on the balance sheet
2. Net the liquid assets and liquid liabilities.
3. Apply shock to the net liquid liabilities.
4. Compute revised liquid liabilities.
5. Compute the revised ratio.
Conclusion
The above methods provide highlight the weak spots and allow the bank to cushion itself accordingly. It also forces the bank to look at case scenarios which it may ignore in the general course of its business since the possibility of their occurrence is quite low. Hence, if used properly and in conjunction with other techniques, stress testing can prove to be a very efficient risk management tool.
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