Learning Objectives:

  • Explain the purpose and methodology of stress testing.

  • Understand the evolution of bank stress testing.

  • Apply stress testing to capital and liquidity assessment.

6.1 The Purpose of Stress Testing

Stress testing is a key risk management tool that assesses a bank’s resilience under severe but plausible adverse scenarios. The University of Leeds module requires students to “Describe and critically evaluate a stress-test analysis of major banking risks” . The IBS training programme covers “Stress Testing” in detail, including “the concept, objectives, and evolution of stress testing in the banking industry” .

Objectives of Stress Testing:

  • Identifying potential vulnerabilities .

  • Assessing capital adequacy under severe conditions .

  • Informing risk appetite decisions.

  • Supporting recovery and resolution planning.

  • Meeting regulatory requirements.

6.2 Stress Testing Techniques

The IBS training programme identifies three key stress testing techniques:

  • Sensitivity Analysis: Assessing the impact of changes in a single risk factor.

  • Scenario Analysis: Assessing the impact of a combination of changes in multiple risk factors.

  • Reverse Stress Testing: Identifying scenarios that could cause bank failure, working backwards from failure to identify triggers .

6.3 Stress Testing and Other Risk Measures

The IBS programme covers the “relationship between stress testing, Value-at-Risk (VaR), Expected Shortfall, and other quantitative risk measures” . While VaR measures potential losses under normal market conditions, stress testing focuses on extreme events.

6.4 Application of Stress Testing

Stress testing is applied to different risk categories :

  • Credit Risk: Assessing the impact of stressed macroeconomic variables on loan defaults and portfolio quality.

  • Market Risk: Evaluating the impact of extreme market movements on trading portfolios.

  • Liquidity Risk: Assessing the bank’s ability to meet obligations under stressed funding conditions.

  • Operational Risk: Evaluating the impact of severe operational events.

6.5 Stress Testing Governance

The IBS programme covers governance requirements, including:

  • Roles and Responsibilities: Board and Senior Management oversight .

  • Policies and Procedures: Documentation of stress testing processes .

  • Validation and Independent Review: Ensuring the accuracy and reliability of stress testing models .

  • Internal Audit: Ensuring compliance with stress testing requirements .

6.6 Managing Portfolios Using VaR

The IBS programme covers “Managing portfolios using VaR” and “Scenario analysis methodologies” . This includes understanding the limitations and assumptions of stress tests .

6.7 Financial Soundness Indicators

The IBS programme includes “Financial Soundness Indicators” as part of stress testing practical applications . These indicators are used to assess the overall health and stability of the banking sector.

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