The Hindu Business Line : Stress testing and Basel accord

STRESS tests were originally developed for use at the portfolio level to understand the latent risks to a trading book from extreme movements in market prices. They have now become widely used as a risk management tool by financial institutions.

What is a `Stress Test'

A `stress test' is a way of revaluing a portfolio using a different set of assumptions. The objective of a stress test is to understand the sensitivity of the portfolio to changes in various risk factors. Stress tests can be applied to both the asset and liability sides of a portfolio.

They can be used to assess a variety of risks, including that of the market (the possibility of losses from changes in prices or yields), credit risk (potential for losses from borrower defaults or non-performance on a contract), and liquidity risk (the possibility of depositor runs or losses from assets becoming illiquid).

Key factors for `Stress Testing'

A number of elements are involved in the design of any stress scenario including the choice of the type of risks to analyse, whether single or multiple risk factors are to be shocked, what parameter(s) to shock (prices, volatilities, correlations), by how much (based on historical or hypothetical scenarios) and over what time horizon .

One of the key decisions is how to calibrate the size of the shocks to use for stress-testing. In general, shocks can be calibrated to the largest past movement in the relevant risk variables over a certain horizon (change from peak to trough or deviation from trend) or be based on historical variance (unconditional or conditional).

Alternatively, with sufficient data, one can attempt to estimate the joint distribution (based on empirical data) of past deviations from trend of the relevant risk variables and use its quantiles for simulating the stress scenario.

It is also important to capture, in the simulated scenario, the second-round effects on any other economic variable that might be affected by the original shock (for example, a severe oil shock is likely to affect GDP as well as inflation, interest rates, etc). Having selected the scope of the portfolio and designed a stress scenario, the impact of macro-economic shocks on the stability of the financial system can be measured using a number of indicators.

FSIs comprise financial sector measures of capital adequacy, asset quality, earnings and profitability, liquidity and real-estate prices. The various risks monitored through financial soundness indicators may all be correlated and are certainly not mutually exclusive (for example, an oil price shock is likely to have repercussions on inflation and interest rates and therefore can be a source of interest rate risk as well as credit and commodity price risk).

Therefore, in order to evaluate the vulnerability of the financial system to a given stress scenario, economists are looking for an integrated risk model that accounts for multiple sources of risk as opposed to relying on different indicators that separately quantify the impact of individual risk factors.

In the integrated approach, the aggregate potential loss from both market and credit risk need to be gauged against the risk-bearing capacity of the banking system.

Stress testing and Basel II

In 1996, the Basel Committee on Banking Supervision recommended that banks using the internal model approach to capital adequacy for market risk have in place a "rigorous and comprehensive stress testing programme." This recommendation gave impetus to a growing awareness and familiarity of stress testing by banks.

The 2004 revised Framework for the New Basel Capital Accord (or Basel II) issued by the Basel Committee on Banking Supervision goes even further in its recommendations with regard to stress testing, in line with the increased emphasis on the use of the internal ratings based approach.

Basel II now calls for banks to use stress tests for a variety of purposes: economic or industry downturns; market-risk events; and liquidity conditions (for lower quality assets). The committee has stated that banks should construct transition matrices based on its own data to stress test its portfolio. Banks should evaluate evidence of ratings migration in external ratings (for instance, Moody's and S&P's). This will help the bank to match its buckets to rating categories.

The test to be employed must be meaningful (given the operating environment) and reasonably conservative. Stress-testing methodologies for credit risk portfolios are still far from consolidated. Besides, the usual data problems on rating migration patterns, correlations or volatility of LGD are even more acute in some portfolios.

Availability of sound stress-test processes for credit portfolios could be also an excessive requirement for medium/small banking institutions that, otherwise, could expect to qualify for the foundation IRB method.

The results of `stress test' will depend on choice and calibration of the stress-scenarios. So it is important to generate the scenarios and time frame in more pragmatic manner. While generating stress tests one need to keep in mind the limitations of quantification of correlation factors between different portfolios and markets.

Another key factor in stress testing under the Basel Accord is to generate transition matrices with the Bank's own data, where Banks in Indian sub-continent will have difficulty, as most of them find it difficult to produce historical data of risk transition and recovery rate.

These institutions have to wait to generate their own matrices, till then they can use external data. Given the increasing incidence of financial crises around the world, paying closer attention to the vulnerabilities of the financial sector from a macro perspective, and enforcing adequate prudential policies, is crucial to prevent the severe costs of bursting financial bubbles. For this, `stress testing' is certainly a useful tool.

(The author is a Business Analyst with Misys Risk Management Systems.)

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