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In markets with increasing volatility and an ever changing economic environment which impacts financial systems banks need a way to quantify the extent of these impacts; stress testing provides that way. Stress Testing is a name given to a wide range of quantitative techniques which are employed by the banks to test the vulnerabilities of their financial systems. The idea is to apply shocks of various degrees on different portfolios and instruments and gauge their affect on the bank’s capital base. Stress Testing is also a regulatory requirement for most regulators. A sample stress testing framework based on a regional central bank prudential requires the banks to submit a stress test report on a semi- annual basis.
We support three prominent stress testing techniques:
a. Simple Sensitivity Analysis
In this type of testing a shock is applied to an independent variable and its impact is assessed independently. There is no consideration for any underlying relationship which may exist between the tested variable and other variables in the system.
b. Scenario Analysis
In this type of testing a shock is applied to a variable and its impact assessed on all other dependent variables and the system as a whole.
c. Extreme Value/Maximum Shock
In this type of testing the level of shock which is applied is so high that it eliminates the capital base completely. Of the three techniques mentioned above, the Simple Sensitivity Analysis is the one required by the State Bank of Pakistan and it is the technique which we shall review for the remaining article.
Focus Areas & Shocks
The regulatory stress testing focuses on the areas of interest rate, non performing loans, stock prices, foreign exchange rate and liquidity risk. Each area is a subjected to minor, moderate and major level shocks. Then the impact of the revised numbers is assessed on the eligible capital, risk weighted assets and the capital adequacy ratio.