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Guidelines on Stress Testing

Globally, banks are increasingly relying on statistical models to measure and manage the financial risks to which they are exposed. These models are gaining credibility because they provide a framework for identifying, analysing, measuring, communicating and managing these risks. Since models cannot incorporate all possible risk outcomes and are generally not capable of capturing sudden and dramatic changes, banks supplement models with ‘stress tests’.

Internationally, stress testing has become an integral part of banks’ risk management systems and is used to evaluate the potential vulnerability to some unlikely but plausible events or movements in financial variables. There are broadly two categories of stress tests used in banks viz. sensitivity tests and scenario tests. These may be used either separately or in conjunction with each other.

Sensitivity tests are normally used to assess the impact of change in one variable (for example, a high magnitude parallel shift in the yield curve, a significant movement in the foreign exchange rates, a large movement in the equity index etc.) on the bank’s financial position.

Scenario tests include simultaneous moves in a number of variables (for example, equity prices, oil prices, foreign exchange rates, interest rates, liquidity etc.) based on a single event experienced in the past (i.e., historical scenario – for example, natural disasters, stock market crash, depletion of a country’s foreign exchange reserves) or a plausible market event that has not yet happened (i.e., hypothetical scenario - for example, collapse of communication systems across the entire region/ country, sudden or prolonged severe economic downturn) and the assessment of their impact on the bank’s financial position.

Banks in India are beginning to use statistical models to measure and manage risks. Stress tests are, therefore, relevant for these banks. Notwithstanding the use of statistical models, stress tests are a relevant and integral part of banks' risk management frameworks. Further, the supervisory review process under Pillar 2 of Basel II framework is intended not only to ensure that banks have adequate capital to support all the risks in their business, but also to encourage banks to develop and use better risk management techniques in monitoring and managing their risks.

In the above background, the need for banks in India to adopt ‘stress tests’ as a risk management tool has been emphasised in the Annual Policy Statement for 2006-07. Accordingly, the draft guidelines on stress testing were prepared and issued for feedback from banks. On the basis of the feedback received, the draft guidelines have been suitably revised. Guidelines on stress testing, as relevant for the Basel II framework, will be issued separately.

Reserve Bank of India in notification dated 26th June 2007 has asked banks to put in place a Board approved ‘Stress Testing framework’ to suit their individual requirements which would integrate into their risk management systems. Banks need to put in place appropriate stress test policies and the relevant stress test framework for the various risk factors by September 30, 2007.

As banks may need to undertake the stress tests on a trial basis and use the results of these trial tests as a feedback to further refine the framework, RBI has decided that banks be allowed some time to refine the stress testing frameworks. Banks are required by RBI to ensure that their formal stress testing frameworks, which are in accordance with the guidelines are operational from March 31, 2008.

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