Stress Testing

The global financial crisis has its origins in the U.S. subprime mortgage crisis of August 2007 The crisis has become a global phenomenon and global growth projections have fallen, stock markets have plummeted, and currencies have lost value against the dollar. Under these circumstances, fitness of banks is important issues for continued existence in crisis with a sound financial system In this context, stress test practice is required for banks to verify their risks and to cope with the crisis eventually Stress testing represents a risk management tool used to evaluate the potential impact on a bank (or a group of entities) of a specific event and / or movement in a set of financial or macro variables. Stress testing has to be regarded as a complementary tool to major risk management instruments such as value-at-risk analysis. The stress tests permit a forward looking analysis.

Stress Testing in Bangladesh The central bank has ordered (April 24,2010) all banks and other financial institutions to undergo stress tests to check whether they are strong enough to hold up in the face of more difficulties and risks. According to Bangladesh Bank (BB) circular banks are instructed to send their respective stress test reports twice a year. The BB must get the reports within 45 days after June 30 and December 31.

Techniques for Stress Testing Simple Sensitivity Analysis (single factor tests) It 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 considered. 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. 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 factors. For example-correlations and volatilities Extreme Value/ Maximum Shock Scenario It measures the change in the risk factor in the worst case scenario, i.e. the level of shock which entirely wipes out the capital. Scope of Stress Test According to BB circular, for Banks & FIs 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

Stress Test at Different Scenario Stress test will be carried out assuming three different hypothetical scenarios Minor Level Shocks- represent small shocks to the risk factors. Moderate Level Shocks-envisages medium level of shocks Major Level Shocks- involves big shocks to all the risk factors.

Methodology and Calibration of Shocks Credit Risk Interest Rate Risk Exchange Rate Risk Equity Price Risk Liquidity Risk

Stress Testing.Final Words