Stress Testing Guidelines

SUBMISSION OF STRESS TESTING REPORT. REF: FSD CIRCULAR NO. 01 DATED 24.09.2012.

REVISED GUIDELINES ON STRESS TESTING. REF: DOS CIRCULAR NO. 01 DATED 23.02.2011.

Bangladesh Bank

Department of Offsite Supervision

GUIDELINES

ON STRESS TESTING

April, 2010

==========

Foreword

It is of vital importance to understand and appreciate the risks the banking industry is exposed to so that soundness and sustainability of the industry can be ensured. Earlier, Bangladesh Bank has issued core risk management guidelines so that banks can develop a sound risk management practice while carrying out their day‐to‐day activities.

In the regulatory and supervisory sphere, the Central Bank’s activities in banking supervision have often been determined by exogenous elements deriving mainly from the changes in the structure and scope; activities and risks that the financial sector is facing and the changes in regulatory standards occurring internationally. The recent financial turmoil in the US financial system has augmented the importance of establishing more developed risk management regime in the financial industry. Present risk management culture based on normal business conditions and historical trends is not enough to cope with the disorders that have happened in the financial systems globally. This required an appropriate response in the regulatory and supervisory activities of the Central Bank.

Financial institutions around the world are increasingly employing stress testing to determine the impact on the financial institution under a set of exceptional, but plausible assumptions through a series of battery of tests. Bangladesh Bank has designed a stress testing framework for banks and FIs to proactively manage risks in line with international best practices. Keeping in view with the divergence of skill levels and available resources among banks and FIs, a modest beginning focused with simple sensitivity and scenario analysis considering only credit risk and market risk is suggested in the Stress Testing Guideline, eventually to develop into a more comprehensive approach.

All banks and FIs are expected to carry out stress testing on half‐yearly basis i.e. on June 30 and December 31 each year with their first stress testing exercise to be based on 30‐06‐ 2010. A training program will be initiated shortly for the relevant staff to ensure smooth implementation of the guidelines.

I would like to appreciate the role of those officers who were involved in this exercise. I also express my gratitude to the honourable Governor, Deputy Governor and Executive Director for their valuable guidance and support in this regard.

Sd/‐

(S.K. SUR CHOWDHURY)

General Manager,

Department of Off‐site Supervision.

Contents

01. Stress testing Page‐01
02. Techniques for Stress Testing 01‐02
03. Framework for Regular Stress Testing 02
04. Scope of Stress Testing 02‐03
05. Methodology and Calibration of Shocks : 03
o Credit Risk : 03
o Increase in NPLs 03
o Shift in NPLs Categories 03
o Fall in Forced Sale Value (FSV) of Mortgaged collateral 03
o Increase in NPLs in particular one or two sector 03
o Increase in NPLs due to default of Top 10 large borrowers 03
o Extreme events 03
o Interest Rate Risk : 04
o Duration GAP & Price Sensitivity 04‐07
o Exchange Rate Risk: 07
o Equity Price Risk: 08
o Liquidity Risk: 08
o Annex‐I Comprehensive Example and Solutions 09‐17
o Annex‐II Reporting Format 18‐21

Guidelines on Stress Testing

1.           Stress Testing:

  • Extreme market movements or crises in the past reveal the inadequacy of managing risks based only on normal business conditions and historical In particular, crises in the 1990’s (e.g. Asian Crisis) and current financial turmoil have augmented the importance of better understanding of potential vulnerabilities in the financial system and the measures to assess these vulnerabilities for both the regulators and the bankers. The regulators and managers of the financial system around the globe have developed a number of quantitative techniques to assess the potential risks to the individual institutions as well as financial system. A range of quantitative techniques that could serve the purpose is widely known as ‘stress testing’. IMF and Basel Committee on banking supervision have also suggested for conducting stress tests on the financial sector.
  • Stress testing is a simulation technique, which are used to determine the reactions of different financial institutions under a set of exceptional, but plausible assumptions through a series of battery of At institutional level, stress testing techniques provide a way to quantify the impact of changes in a number of risk factors on the assets and liabilities portfolio of the institution. For instance, a portfolio stress test makes a rough estimate of the value of portfolio using a set of exceptional but plausible events in abnormal markets. However, one of the limitations of this technique is that stress tests do not account for the probability of occurrence of these exceptional events. For this purpose, other techniques, for example VAR (value at risks) models etc, are used to supplement the stress tests. These tests help in managing risk within a financial institution to ensure optimum allocation of capital across its risk profile.
  • At the system level, stress tests are primarily designed to quantify the impact of possible changes in economic environment on the financial The system level stress tests also complement the institutional level stress testing by providing information about the sensitivity of the overall financial system to a number of risk factors. These tests help the regulators to identify structural vulnerabilities and the overall risk exposure that could cause disruption of financial markets. Its prominence is on potential externalities and market failures.

2.     Techniques for Stress Testing:

  1. Simple Sensitivity Analysis (single factor tests) measures the change in the value of portfolio for shocks of various degrees to different independent risk factors while the underlying relationships among the risk factors are not For example, the shock might be the adverse movement of interest rate by 100 basis points and 200 basis points. Its impact will be measured only on the dependent variable i.e. capital in this case, while the impact of this change in interest rate on NPLs or exchange rate or any other risk factor is not considered.
  2. Scenario Analysis encompasses the situation where a change in one risk factor affects a number of other risk factors or there is a simultaneous move in a group of risk Scenarios can be designed to encompass both movements in a group of risk factors and the changes in the underlying relationships between these variables (for example correlations and volatilities). Stress testing can be based on the historical scenarios, a backward looking approach, or the hypothetical scenario, a forward‐looking approach.

  1. Extreme Value/ Maximum Shock Scenario measures the change in the risk factor in the worst‐case scenario, e. the level of shock which entirely wipes out the capital.

 3.  Framework for Regular Stress Testing:

The stress‐testing framework involves the scope of the risks covered and the process/procedure to carry out the stress test. This framework should be flexible enough to adopt advanced models for stress testing. It involves:

  • A well constituted organizational structure defining clearly the roles and responsibilities of the persons involved in the Preferably, it should be the part of the risk management functions of the bank/FI. The persons involved should be independent from those who are actually involved in the risk taking and should directly report the results to the senior management.
  • Defining the coverage and identifying the data required and
  • Identifying, analyzing and proper recording of the assumptions used for stress
  • Calibrating the scenarios or shocks applied to the data and interpreting the
  • An effective management information system that ensures flow of information to the senior management to take proper measures to avoid certain extreme
  • Setting the specific trigger points to meet the benchmarks/standards set by Bangladesh
  • Ensuring a mechanism for an ongoing review of the results of the stress test exercise and reflecting in the policies and limits set by management and board of
  • Taking this stress test as a starting point and developing in‐house stress test model to assess the bank/FI’s specific risks

4.     Scope of Stress Test :

As a starting point the scope of the stress test is limited to simple sensitivity analysis. Five different risk factors namely; interest rate, forced sale value of collateral, non‐performing loans (NPLs), stock prices and foreign exchange rate have been identified and used for the stress testing. Moreover, the liquidity position of the institutions has also been stressed separately. Though the decision of creating different scenarios for stress testing is a difficult one, however, to start with, certain levels of shocks to the individual risk components have been specified considering the historical as well as hypothetical movement in the risk factors.

  • Stress test shall be carried out assuming three different hypothetical scenarios:

  • Minor Level Shocks: These represent small shocks to the risk The level for different risk factors can, however, vary.
  • Moderate Level Shocks: It envisages medium level of shocks and the level is defined in each risk factor
  • Major Level Shocks: It involves big shocks to all the risk factors and is also defined separately for each risk
    • Assumptions behind each Scenario: The stress test at this stage is only a single factor sensitivity Each of the five risk factors has been given shocks of three different levels. The magnitude of shock has been defined separately for each risk factor for all the three levels of shocks.

5.  Methodology and Calibration of Shocks :

  • Credit Risk :

The  stress  test  for  credit  risk  assesses  the  impact  of  increase  in  the  level  of  non‐ performing loans of the bank/FI. This involves six types of shocks:

  • The first deals with the increase in the NPLs and the respective The three scenarios shall explain the impact of 1%, 2% and 3% of the total performing loans directly downgraded to bad/loss category having 100% provisioning requirement.
  • The second deals with the negative shift in the NPLs categories and hence the increase in respective The three scenarios shall explain the impact of 50%, 80% and 100% downward shift in the NPLs categories. For example, for the first level of shock 50% of the SMA shall be categorized under substandard, 50% of the substandard shall be categorized under doubtful and 50% of the doubtful shall be added to the bad/loss category.
  • The third deals with the fall in the forced sale value (FSV) of mortgaged collateral. The forced sale values of the collateral shall be given shocks of 10%, 20% and 40% decline in the forced sale value of mortgaged collateral for all the three scenarios
  • The fourth deals with the increase of the NPLs in particular 1 or 2 sector i.e. garments & Textiles and the respective provisioning. The three scenarios shall explain the impact of 5%, 5% and 10% performing loans of particular 1 or 2 sectors directly downgraded to bad/loss category having 100% provisioning requirement.
  • The fifth deals with the increase of the NPLs due to default of Top 10 large borrowers and the respective provisioning. The three scenarios shall explain the impact of 5%, 5% and 10% performing loans of Top 10 large borrowers directly downgraded to bad/loss category having 100% provisioning requirement.
  • The sixth deals with extreme events in which due to increase in the certain percentage of NPLs, the whole capital position of a bank will be wiped out to offset the increased amount of provision due to cover respective loan The forced sale value of the collaterals and tax‐adjusted impact of the additional required provision (if any) will be calibrated in the CAR for the each scenario under all categories.

Ø  Interest Rate Risk:

Interest rate risk is the potential that the value of the on‐balance sheet and the off‐ balance sheet positions of the bank/DFI would be negatively affected with the change in the interest rates. The vulnerability of an institution towards the adverse movements of the interest rate can be gauged by using duration GAP analysis.

The banks and FIs shall follow the following steps in carrying out the interest rate stress tests:

  • Estimate the market value of all on‐balance sheet rate sensitive assets and liabilities of the bank/DFI to arrive at market value of equity
  • Calculate the durations of each class of asset and the liability of the on‐balance sheet portfolio Arrive at the aggregate weighted average duration of assets and liabilities
  • Calculate the duration GAP by subtracting aggregate duration of liabilities from that of
  • Estimate the changes in the economic value of equity due to change in interest rates on on‐balance sheet positions along the three interest rate
  • Calculate surplus/(deficit) on off‐balance sheet items under the assumption of three different interest rate changes e. 1%, 2%, and 3%
  • Estimate the impact of the net change (both for on‐balance sheet and off‐balance sheet) in the market value of equity on the capital adequacy ratio (CAR).

Market value of the asset or liability shall be assessed by calculating its present value discounted at the prevailing interest rate. The outstanding balances of the assets and Liabilities should be taken along with their respective maturity or repricing period, whichever is earlier.

v Duration GAP & Price Sensitivity

Duration is the measure of a portfolio’s price sensitivity to changes in interest rates. Longer the duration, larger the changes in the price for a given change in the interest rates. Larger the coupon, lower would be the duration  and smaller would be the change in the price for a given change in the interest rates. The duration is measured as:

 

 

n

n
å

t * CFt

+                                            t

å
n

D =  t=1 (1

YTM)

CF

t

(1+ YTM)t

t=1

n
å

t * CFt

+                                            t

= t=1 (1

YTM)

Pv(Security)

Where

CFt= cash flow at time t,

t = the number of periods of time until the cash flow payment,

1

YTM = the yield to maturity

of the security generating the cash flow, and

n = the number of cash flows.

Examples:
  • The duration of a bond of 100 with the maturity of 3 years, 10% coupon and the effective YTM at 8% will be calculated as follows:

  10×1    +   10×2    

  10×3     

  100×3     

D=

(1.08)

(1.08)2       +

(1.08)3       +

(1.08)3

  288.38    

10       +        10                 10

                = 100

105.15      =     2.74 years

(1.08)

(1.08)2       +

(1.08)3       +

(1.08)3

  • The duration of the same bond if the YTM declines to 4%:

  10×1    +   10×2    

  10×3     

  100×3     

(1.04)

(1.04)2       +

(1.04)3       +

(1.04)3

  321.48    

D=

10       +        10                 10

                = 100

116.65      =     2.76 years

(1.04)

(1.04)2       +

(1.04)3       +

(1.04)3

1The yield to maturity for zero coupon bonds and for other interest earning assets and liabilities would be the current market interest rates thereon.

 

 

05

  • The duration GAP is measured by comparing the weighted average duration of assets

2

with the weighted average duration of liabilities (leverage‐adjusted) . The weighted average

duration of assets and liabilities is calculated as follows:

n

Weighted Average Duration of Assets (DA)       =      WaDa

a

m

Weighted Average Duration of Liabilities (DL)   =   ∑WlDl

l

Where

Wa = market value of the asset adivided by the market value of all the assets   Wl = market value of the liability l divided by the market value of all the liabilities Da = duration of the asset a

Dl = duration of the liability l n =  total number of assets

m =   total number of liabilities

  • The duration GAP indicates how the market value of equity (MVE) of a bank/FI will change with a certain change in interest If the weighted average duration of assets exceeds the weighted average duration of liabilities (leverage‐adjusted), the duration GAP is said to be positive. A positive duration gap signifies that the assets are relatively more interest rate sensitive than liabilities. Hence if the interest rates rise, the value of assets will fall proportionately more than the value of liabilities and the market value of equity will fall accordingly and vice versa. Duration Gap will be calculated as under:

DGAP    =   DA ‐     (MVL)      X DL

(MVA)

The change in market value of equity shall be calculated as:

∆ MVE   @  (‐DGAP)X       ∆i        X Total Assets

(1+y)

i = The change in the interest rate

y = The effective yield to maturity of all the assets

2 The leverage adjustment takes into account the existence of equity as a means of financing assets.

 

06

  • The impact of interest rate change on interest bearing off‐balance sheet contracts shall be separately As a first step, the actual market price of each contract shall be determined which should represent the actual price of the contract if sold immediately. The second step involves calculating the market price again by marking to market each contract separately assuming a change in interest rate. The difference between the two market prices would determine the amount of revaluation surplus or deficit. The revaluation surplus would arise if the actual market price of the contract is less than the price calculated after assuming a change in the interest rate and revaluation deficit would result in, if otherwise. The revaluation surplus/deficit arising due to the change in the interest rates of the off‐balance sheet contracts should be subtracted/ added to the fall in market value of equity derived by the DGAP approach to arrive at the net change in the market value of equity.
  • The impact of this net change in the market value of equity will then be calibrated in the The tax‐adjusted impact of this net fall (if any) in the MVE shall be adjusted from the regulatory capital and the risk‐weighted assets and the revised CAR shall be calculated under each of the above scenarios.

Ø Exchange Rate Risk :

  • The stress test for exchange rate assesses the impact of change in exchange rate on the value of To assess foreign exchange risk the overall net open position of the bank/FI including the on‐balance sheet and off‐balance sheet exposures shall be charged by the weightage of 5%, 10% and 15% for minor, moderate and major levels respectively. The overall net open position is measured by aggregating the sum of net short positions or the sum of net long positions; whichever is greater. For example, the bank may have net long position of Tk.500 million in Yen, Euro and USD and the net short position in GBP and Australian dollar of Tk.600 million. The total exposure will be the greater of the two i.e. sum of the short positions of Tk.600 million. The impact of the respective shocks will have to be calibrated in terms of the CAR. The tax‐adjusted loss if any arising from the shocked position will be adjusted from the capital. The revised CAR will then be calculated after adjusting total loss from the risk‐weighted assets of the bank/FI.

Ø  Equity Price Risk :

The stress test for equity price risk assesses the impact of the fall in the stock market index. Appropriate shocks will have to be absorbed to the respective securities if the current market value of all the on balance sheet and off balance sheet securities listed on the stock exchanges including shares, NIT units, mutual funds etc falls at the rate of 10%, 20% and 40% respectively. The impact of resultant loss will be calibrated in the CAR.

Ø  Liquidity Risk :

The stress test for liquidity risk evaluates the resilience of the banks towards the fall in liquid liabilities. The ratio “liquid assets to liquid liabilities” shall be calculated before and after the application of shocks by dividing the liquid assets with liquid liabilities. Liquid assets are the assets that are easily turned into cash without the threat of loss. They include cash, balances with Bangladesh Bank and balances with banks, call money lending, lending under repo and investment in government securities. Liquid liabilities include the deposits and the borrowings. Appropriate shocks will have to be absorbed to the liquid liabilities if the current liquidity position falls at the rate of 10%, 20% and 30% respectively. The ratio of liquid assets to liquid liabilities shall be re‐calculated under each scenario.