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 on historical data and assumptions. It helps the senior management in understanding the condition of the bank in the stressed time. Stress testing outputs are used by a bank in decision making process in terms of potential actions like risk mitigation techniques, contingency plans, capital and liquidity management in stressed conditions, etc.It focuses on the impact of credit risk, liquidity risk, market risk etc. in adverse situations both at the bank level and at the systemic level. Stress tests measure the resilience of the individual financial institutions as well as the financial systems as a whole against possible extreme volatilities in the macro economic parameters in any country’s financial system.
Stress testing forms an integral part of the internal capital adequacy assessment process (ICAAP), which requires banks to undertake rigorous, forwardlooking stress testing that identifies severe events or changes in market conditions that could adversely impact the bank. The main objectives of stress testing includes assistance in risk identification and control, complementing other risk management tools, improving capital and liquidity planning, and thereby facilitating the business decision-making. Stress tests plays an important role in the communication of risk within the bank and external communication with supervisors to provide support for internal and regulatory capital adequacy assessments .Indian Banks perform the stress tests at least at half yearly intervals.
As per RBI guidelines ,The responsibility for stress testing programme in a bank rests with the board of directors of the bank and with the Chief Executive Officer in the case of the foreign banks with branch presence in India. To promote risk identification and control, stress testing is included in risk management activities of a bank at various levels . It is used to address existing or potential firm-wide risk exposures and concentrations. In Banks stress testing programme is governed by internal policies and procedures and they document the underlying assumptions and fundamental elements for each stress testing exercise. For this banks have proper MIS in place and ensure maintaining proper infrastructure.
There are broadly two categories of stress tests used in banks namely sensitivity tests and scenario tests. Sensitivity analysis estimates the impact on a bank’s financial position due to predefined movements in a single risk factor like interest rate, foreign exchange rate or equity prices, shift in probabilities of defaults . In the sensitivity analysis, the source of the shock on risk factors is not identified and usually, the underlying relationship between different risk factors or correlation is not considered .Scenario Analysis seeks to assess the potential consequences for a firm of an extreme but possible state of the world. This analysis is based on a historical event or hypothetical event. Scenario analysis is currently the leading stress testing technique.The banks identify relevant risk drivers. And subsequently the banks stress the identified risk drivers using different degree of severity.
There is also concept of Reverse stress testing which is a technique that involves assuming worst stressed outcome and tracing the extreme event/shocks that bring the maximum impact. Reverse stress testing starts from an outcome of business failure and identifies circumstances where this might occur. It is seen as one of the risk management tools usefully complementing the “usual” stress testing, which examines outcomes of predetermined scenarios. For the classification of banks for stress testing , banks have been classified into 3 groups as below:
Group A – Bank with Total Risk Weighted Assets(RWA) of more than Rs.2000 billion
Group B – Bank with Total Risk Weighted Assets between Rs.500 billion and Rs.2000 billion
Group C – Bank with Total Risk Weighted Assets less than Rs.500 billion
A bank that falls under Group A should carry on stress testing programmes with all the complexities and severities required for programmes to be realistic and meaningful. A bank that falls under Group B, conduct multifactor sensitivity analysis and simple scenario analyses of the portfolios with respect to simultaneous movements in multiple risk factors caused by an event. A bank that falls under Group C conduct simple sensitivity analyses of the specific risk types to which it is most exposed. This will allow such bank to identify, assess and test its resilience to shocks relating to the material risks to which its portfolios are exposed.
When the stress tests are not favourable for financial institutions then following scenarios occurs:
- No Dividend payment to their shareholders
- High plough back of profit and thereby shore-up their net worth
In case of failed stress tests for banks/FI following scenarios occur:
- Rework their business plan
- Restructure their assets portfolio
- Do the stress tests in a simulated environment
- Resubmit the results of the revised stress tests.
RBI has time to time laid stress on Stress Testing as it consider market illiquidity and the interplay of market and credit risk. Due to outbreak of Corona pandemic in the year 2020 and to judge the impact of it on banks/NBFCs RBI in June 2020 , advised all banks and NBFCs to do Covid stress tests and analyse the impact on balancesheet, asset quality, liquidity, profitability and capital adequacy for FY21 and FY22 and based on the outcome of such stress testing, banks and NBFCs have been advised to work out possible mitigating measures including capital planning, capital raising, and contingency liquidity planning. This year also RBI may asks bank to perform the stress tests to judge the impact of second phase of COVID 19 . In its Financial stability report released on 11 January 2021 , RBI said gross NPAs could rise to 13.5% under the baseline stress scenario by 30 September 2021, the highest in more than 22 years, up from 7.5% as of 30 September 2020. It is predicted to almost double to 14.8% under a severe stress scenario. Hence Regulator is now looking for multiple indicators like credit disbursement, adoption of information technology across banks etc. for the comprehensive stress tests.
Hence we see that stress tests has a great importance . It helps not only in managing funding risk taking into consideration all relevant market rates but also produce information summarizing the bank’s exposure to extreme but possible circumstances.