Govind Gurnani
Stress Testing: Best Risk Measurement Tool In Banks
Global financial crisis 2008 was a turning point for banks and financial
institutions across the world that put the need for more stringent stress
testing practices on forefront. Prior to this, stress testing was a part of the
Internal Capital Adequacy Assessment Program (ICAAP) under the Basel
Committee on Banking Supervision (BCBS) norms.
In the recent times, stress testing has emerged as a common tool for
financial supervision and regulation for the central banks in many
countries undertaking related reforms. The International Financial
Reporting Standard (IFRS) 9 has prescribed stress testing for banks and
financial institutions as an exercise to determine the volatility in the
expected credit loss in baseline and adverse scenarios such as
significant deceleration in GDP growth or sharp decrease in
unemployment rates.
In terms of degree of severity, a scenario can be described as either
"baseline" or "adverse":
▪ Baseline scenario: a set of economic and financial conditions that is
generally consistent with the projection of a likely path for future
economic and financial conditions. The baseline scenario usually does not
lead to a stressed result.
▪ Adverse scenario: a set of economic and financial conditions which is
designed to stress the performance of the banking sector or an individual
bank. The level of stress is significantly stronger than in a baseline
scenario.
In India, the Reserve Bank of India (RBI) emphasised on stress testing as a
risk management tool and issued formal guidelines in June 2007. After the
global financial crisis, the banking regulator also updated its stress testing
guidelines in 2013 based on BCBS principles. Banks and Financial
institutions in India mainly follow ‘Top-down Approach’ to implement
stress testing norms. The top-down approach is simple, requires minimal
technology infrastructure and is quick to complete. Mom qmqw MM
Stress testing is described as the evaluation of a bank's financial position
under a severe but plausible scenario to assist in decision making within
the bank. It enables a bank in forward looking assessment of risks, which
overcomes the limitations of statistical risk measures or models based
mainly on historical data and assumptions. It also facilitates internal and
external communication and helps senior management understand the
condition of the bank in the stressed time.
Two Approaches for Stress Testing
◾ Top-down Approach: The top-down approach evaluates the impact
of shocks to macroeconomic variables on a bank’s balance sheet or income
statement categories. It is more predictable and produces stable results. It
helps figure out whether the bank has enough capital to survive stressful
conditions. For instance, it stresses the net non-performing assets level and
studies its impact on the bank’s capital levels. However, it does not
correctly account for exposures created by offbalance sheet instruments. It
is a single aggregated model of the balance sheet. It does not capture the
idiosyncratic risk (viz. risk that is particular to a specific investment – as
opposed to risk that affects the entire market or an entire investment
portfolio) of the bank. The top-down model does not adequately assess
risks or enable revenue forecasting. As a result, Indian banks are today
weighed down by a high number of non-performing assets.
◾ Bottom-up Approach : The bottom-up approach is a time
consuming approach that evaluates the impact of shocks to
macroeconomic variables on the bank but at the most granular level data.
This considers shocks at individual customer levels, their credit ratings,
instruments of investments such as equity, debt etc. The results are then
aggregated to give a firm wide view of the impact on the bank’s capital
levels. It depends a lot on revenue and expense forecasting models and
collateral valuation models. It captures the exposures created by off-
balance sheet instruments in a reasonable manner through various
forecasting models. It also captures the idiosyncratic risk of the bank. For
instance, a bank focusing on the wholesale banking can follow different
models from the bank that focuses on retail banking.
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