Basel II guidelines on stress testing
Basel II highlights
Stress testing should be actionable, with clear link to decision making at the
appropriate management level
Function must challenge assumptions, especially historical assumptions
The risk management function must involve business units in the stress tests
Stress testing for the bank must be conducted centrally
Identify comprehensive list of risks that affect the bank and aggregate common risks
Identify system-wide interactions and feedback effects
Sensitivity tests and scenario analysis are recommended
For sensitivity tests: Single parameter and simultaneous shocks
For scenario analysis: Hypothetical stress tests over historical scenarios
Changes in response to crisis
Review scenarios more frequently and look for new risks
Identify correlations and aggregate risks across exposures, including operational,
market, and credit risk
Systematically challenge effectiveness of risk mitigation measures
Explicitly consider risks to complex products like structured products, off-balance-
Enhance stress testing to capture effects of reputational risk and illiquidity
Range of stress tests. While VaR analysis identifies capital that protects the bank from business-as-usual risk, the role of stress testing is to protect the bank from low- probability “known unknowns” and “unknown unknowns” (see Exhibit 5 on the following page).
Scenario analysis helps identify macro-economic and industry scenarios that are based on known drivers of risk across the portfolio. These scenarios are then used to stress PD/LGD/EAD and correlations across the portfolio. This is an integrated and consistent approach to capturing simultaneous stress across various business drivers of portfolio risk.
Systemic uncertainty stress is needed to measure the impact of “unknown unknowns” on the portfolio. Every downturn is characterized by new, unanticipated uncertainties. While it is impossible to predict these, modeling the increased uncertainty during
periods of crisis impact.
e.g., by increasing volatility of parameters – helps to capture their
Impact on decision making. Best-practice banks use the results of stress testing to inform all types of strategic decisions, including business exit and entry and investment. Stress testing is an integral part of active credit portfolio management. The VaR-model- based economic capital estimation is complemented by stress scenario requirements of economic capital. Likewise, pricing decisions and RAROC thresholds are set based on stress-scenario results.