Basel II and the Crisis – 15 Recommendations to the Banks That (Sort Of) Use Stress Testing
Recommendations to banks
- Stress testing should form an test bank part of the overall governance and risk management culture of the bank. It should be actionable, with the results from analyses impacting decision making at the appropriate management level, including strategic business decisions of the board and senior management.
Board and senior management involvement 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 programme. The operation of the programme should be appropriately documented.
- A bank should have a suitably robust infrastructure in place, which issufficiently flexible to accommodate different and possibly changing tests at an appropriate level of granularity.
- A bank should regularly maintain and update its framework.
The effectiveness of the 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 across the range of its testing activities to deliver a complete picture of firm-wide risk.
- Programmes should cover a range of scenarios, including forward-looking scenarios, and aim to take into account system-wide interactions and feedback effects.
- Tests should be geared towards the events capable of generating most damage whether through size of loss or through loss of reputation.
A 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 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 programme should explicitly cover complex and bespoke products such as securitised exposures.
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 programme should cover pipeline and warehousing risks.
A bank should include such exposures in its tests regardless of their probability of being securitised.
- A bank should enhance its 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 programme.
- A bank should enhance its 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.