Banks, DFIs capacity boost: SBP revises guidelines on stress testing

The State Bank of Pakistan (SBP) has revised the guidelines on stress testing in conformity with international standards and improved capacity of banks/Development Finance Institutions (DFIs) to perform such analysis.
The revised guidelines, which will further strengthen the risk management capacity of banks and DFIs, have been divided into three sections; Section 1 prescribes standards for designing and implementing the stress-testing framework, Section 2 delineates the mandatory set of stress tests for credit, market and liquidity risk factors using sensitivity analysis and Section 3 provides guidance on optional stress tests for operational risk, Islamic banking and advanced approaches, including scenario analysis, and reverse stress tests, says BSD Circular No. 1 of May 11, 2012.
Section 1 of the revised guidelines contains a brief review of stress testing concepts as well as some broad guidelines on establishing a robust stress testing framework. Section 2 elaborates the mandatory set of predefined stress tests, based on sensitivity analysis, that all banks/DFIs are required to conduct and report their results to SBP on quarterly basis. Section 3 provides some additional guidance on non-mandatory stress tests that banks/DFIs are encouraged to consider for their internal consumption.
All banks and DFIs have been advised to submit the results of the stress tests as specified in Section 2 on the prescribed format of these Guidelines to the Banking Surveillance Department of SBP on quarterly basis, starting from quarter ending June 30, 2012, within 30 days of the close of each quarter, the Circular added.
Under this section the mandatory tests cover credit, market, and liquidity risk and contain three levels of shocks under each scenario. The three levels of shocks are defined as (i) Minor, (ii) Moderate, and (iii) Major shocks. This classification reflects the intensity of the shocks and magnitude of their impact. According to the revised guidelines, the mandatory stress tests (Section 2) are minimum requirements to promote a culture of stress testing in banks/DFIs. However, SBP encourages banks/DFIs to conduct additional stress tests, for their in-house consumption that are commensurate with the size and complexity of their operations.
This section 3 provides guidance on designing more sophisticated stress tests, which, at present, are optional and include scenario analysis and reverse stress tests and stress tests for operational risk. Moreover, Islamic Banking Institutions (IBIs) are also encouraged to design stress tests as per their unique risk profile. Banks/DFIs should endeavor to build their capacity to regularly use these tests for internal consumption. Large banks, with a share of 4% or above in total assets of the banking system are required to start working on advanced approaches - the scenario analysis and reverse stress tests, and share the same with SBP by December, 31, 2012.
Stress testing is a risk management tool that helps identify the potential impact of extreme yet plausible events or movements on the value of a portfolio. Stress tests help identify and analyze the risks which might be latent under benign conditions but, if triggered, could have serious implications for the very existence of a financial institution.