On 20^th May 2009, Basel Committee on Banking Supervision of Bank for International Settlements came out with a set of sound principles for sound stress testing practices and supervision. For an introduction to the topic stress testing on banks, readers are invited to browse through my earlier blog on 17^th May 2009.

According to Bank for International Settlements, stress testing is an important risk management tool that is used by banks as part of their internal risk management exercise. It is especially important after long periods of benign economic and financial conditions, when fading memory of negative conditions can lead to complacency and the under pricing of risk. It is also a key risk management tool during periods of expansion, when innovation leads to new products that grow rapidly and for which limited or no loss data is available.

Bank for International Settlements has identified the following principles for sound stress testing practices and supervision as applicable to large complex banks.

- Stress testing should form an integral part of the overall governance and risk management culture of the bank. Stress testing should be actionable, with the results from stress testing analyses impacting decision making at the appropriate management level, including strategic business decisions of the board and senior management. Board and senior management involvement in the stress testing programme is essential for its effective operation.

- A bank should operate a stress testing programme that promotes risk identification and control; provides a complementary risk perspective to other risk management tools; improves capital and liquidity management; and enhances internal and external communication.

- Stress testing programmes should take account of views from across the organisation and should cover a range of perspectives and techniques.

- A bank should have written policies and procedures governing the stress testing programme. The operation of the programme should be appropriately documented.

- A bank should have a suitably robust infrastructure in place, which is sufficiently flexible to accommodate different and possibly changing stress tests at an appropriate level of granularity.

- A bank should regularly maintain and update its stress testing framework. The effectiveness of the stress testing programme, as well as the robustness of major individual components, should be assessed regularly and independently.

- Stress tests should cover a range of risks and business areas, including at the firm-wide level. A bank should be able to integrate effectively, in a meaningful fashion, across the range of its stress testing activities to deliver a complete picture of firm-wide risk.

- Stress testing programmes should cover a range of scenarios, including forward-looking scenarios, and aim to take into account system-wide interactions and feedback effects.

- Stress tests should feature a range of severities, including events capable of generating the most damage whether through size of loss or through loss of reputation. A stress testing programme should also determine what scenarios could challenge the viability of the bank (reverse stress tests) and thereby uncover hidden risks and interactions among risks.

- As part of an overall stress testing programme, a bank should aim to take account of simultaneous pressures in funding and asset markets, and the impact of a reduction in market liquidity on exposure valuation.

- The effectiveness of risk mitigation techniques should be systematically challenged.

- The stress testing programme should explicitly cover complex and bespoke products such as securitised exposures. Stress tests for securitised assets should consider the underlying assets, their exposure to systematic market factors, relevant contractual arrangements and embedded triggers, and the impact of leverage, particularly as it relates to the subordination level in the issue structure.

- The stress testing programme should cover pipeline and warehousing risks. A bank should include such exposures in its stress tests regardless of their probability of being securitized.

- A bank should enhance its stress testing methodologies to capture the effect of reputational risk. The bank should integrate risks arising from off-balance sheet vehicles and other related entities in its stress testing programme.

- A bank should enhance its stress testing approaches for highly leveraged counterparties in considering its vulnerability to specific asset categories or market movements and in assessing potential wrong-way risk related to risk mitigating techniques.

- Supervisors should make regular and comprehensive assessments of a bank’s stress testing programme.

- Supervisors should require management to take corrective action if material deficiencies in the stress testing programme are identified or if the results of stress tests are not adequately taken into consideration in the decision-making process.

- Supervisors should assess and if necessary challenge the scope and severity of firm-wide scenarios. Supervisors may ask banks to perform sensitivity analysis with respect to specific portfolios or parameters, use specific scenarios or to evaluate scenarios under which their viability is threatened (reverse stress testing scenarios).

- Under Pillar 2 (supervisory review process) of the Basel II framework, supervisors should examine a bank’s stress testing results as part of a supervisory review of both the bank’s internal capital assessment and its liquidity risk management. In particular, supervisors should consider the results of forward-looking stress testing for assessing the adequacy of capital and liquidity.

- Supervisors should consider implementing stress test exercises based on common scenarios.

- Supervisors should engage in a constructive dialogue with other public authorities and the industry to identify systemic vulnerabilities. Supervisors should also ensure that they have the capacity and skills to assess a bank’s stress testing programme.

Well. These principles enunciated by Bank for International Settlements are quite comprehensive and will require resources with specialist skills. Instead of expecting each bank to take up this assignment, the Central Banks in respective countries could undertake the exercise on an on-going basis and come out prescriptions for the banks. Only then one can expect its application across all banks uniformly.