Fundamental Stress Testing Procedure for Private commercial Bank in Bangladesh

***Tamzidul Islam Chowdhury Introduction: The global financial crisis has its origins in the U.S. subprime mortgage crisis of August 2007. It seemed initially that it would only affect developed countries, but the so-called decoupling phenomenon, which predicted that developing countries would remain unaffected, has not occurred. Instead the crisis has become a global phenomenon and global growth projections have fallen, stock markets have plummeted, and currencies have lost value against the dollar. However, this crisis has several downside risks for the Bangladesh economy. Bangladesh is not yet affected barely but the impact on the Bangladesh economy will depend on the nature, scope, severity and duration of the crisis. Although the economy of Bangladesh has become increasingly integrated with the global economy in recent years but the countrys financial sector is not as globally integrated as its neighbors countries. Therefore, countries financial markets have not so far to feel any direct impacts. The banking sector is mostly separated from international financial markets and does not have sophisticated products. Therefore the risks remain mainly in the area of export earning, remittances and foreign aid, which may perhaps, creates macroeconomic shocks in economy. Under these circumstances, fitness of banks is important issues for continued existence in crisis with a sound financial system. Banks might lose their deposits by falling remittances and banks existing nonperforming loan would become double, if a major shock creates in exports sector. In this context, stress test practice is required for banks to verify their risks and to cope with the crisis eventually. Usually, Stress testing represents a risk management tool used to evaluate the potential impact on a bank (or a group of entities) of a specific event and / or movement in a set of financial or macro variables. It is important to note that stress testing has to be regarded as a complementary tool to major risk management instruments such as value-at-risk analysis. The stress tests permit a forward- looking analysis and a uniform approach to identifying potential risks, generated by exceptional but plausible shocks to the banking system as a whole. Banks perform stress tests for their internal needs in order to identify reaction of sectors to extreme events; assess the sensitivity of credit factors and approaches to extreme events in order to ensure appropriateness; identify hidden correlations within portfolio; support portfolio allocations decisions and strategy beyond normal current conditions; evaluate potential capital requirements under possible future credit environments; and identify benchmarks to create some awareness of the current market situation. Bangladesh bank is already taken some practices but not sufficient for impending crisis. Individual bank should do this immediately to identify where risk are concentrate and understand the impact on bank balance sheet, if biggest customers default. The paper aimed at laying down the main elements of the banks stress testing methodologies conveniently, as captured by relevant international guidance.

Literature review: The International Monetary Fund (IMF) and the World Bank (WB) have initiated theFinancial Sector Assessment Program (FSAP), which strives to assess strengths and vulnerabilities in their member countries financial systems. The assessments under this program have so far covered more than 50 jurisdictions and provided various recommendations for improvement in the financial system framework

(many of the assessments are available on the IMF and WB websites). Stress testing was from the beginning a key element of the assessment of financial sector stability. Stress testing in the FSAP has evolved. Most FSAP missions to date have included single-factor sensitivity analysis based on historical extreme values, although an increasing number have also applied scenario analyses, using multiple techniques to determine the size of shocks. While almost all stress tests relied on data provided by the authorities, the involvement of the authorities in the recent FSAP missions has gone beyond providing data, as they have also been actively involved in designing and implementing stress tests in the recent FSAP missions. Moreover, recent FSAP missions to industrialized countries have aimed to improve the effectiveness of stress tests through the use of macroeconomic models, the analysis of contagion resulting from interbank exposures, and the involvement of major financial institutions in the stress testing exercise (IMF and the World Bank, 2003). The availability and quality of data impose major constraints on the nature of the stress tests that can be performed. Data limitations have come in three forms: (i) basic data availability, especially in countries where information on key exposures may not be available; (ii) an inability to isolate the desired exposures in a financial institution, especially in the case of complex financial institutions or institutions which are active in the derivative markets; and (iii) confidentiality issueslimitations on what the authorities are legally able to share with the mission. The experience of the FSAP to date suggests that the types of stress tests need to be tailored to countryspecific circumstances, the complexity of the financial system, and data availability. In industrialized countries, the analysis can be strengthened by using macroeconomic models (to help calibrate the scenarios and arrive at a consistent set of assumptions for the tests), the analysis of interbank contagion, and the involvement of major banks in the stress testing exercise (IMF and World Bank, 2003). The experience also suggests that stress tests can have a number of benefits. In particular, they can help define the amount and nature of the data required for ongoing monitoring of financial stability, thereby playing an important role of capacity building. They can also provide an independent verification of potential sources of vulnerability and broaden the understanding of linkages in the financial system (IMF and World Bank, 2003). Several central banks have started conducting a regular stress testing exercise following the FSAP, some central banks have increased regulatory attention to stress tests done by commercial banks, and some central banks have asked for follow-up technical assistance with establishing a framework for conducting stress tests on a regular basis.

Financial soundness indicators and risk analysis for banks:

Risk assessment analysis for banks will be based on financial soundness indicator (FSI). FSIs monitoring banks return on equity and return on assets indicate the extent to which earnings are available to absorb

losses before capital is impacted. The various measures used in this regards are ROA, ROE, interest margin to gross income, and liquid assets to total assets. In using capital ratios to assess financial strength for banks, attention needs to be paid to the quality of the capital. The reason is that the capacity of capital to absorb losses in the event of insolvency differs for different types of capital. Attention also needs to be paid to the definition, consolidation rules and valuation approaches used in reported capital measures, since they can differ across countries. Now we discuss about the key functions of FSIs in terms of banks stress test. First of all, FSIs of asset quality monitor the loan quality and exposure concentrations of banks asset portfolios. Loan quality is measured by the ratio of NPLs to total loans. FSIs of the sectoral and geographic distribution of loans to total loans monitor vulnerabilities arising from concentrated lending exposures to particular sectors or countries. On the other hand, FSIs of sensitivity to market risk monitor the vulnerability of the financial sector to exchange rate, interest rate and equity market risk. Secondly, The FSIs of the duration of assets and liabilities are intended to measure interest rate risk associated with the assets and liabilities, respectively. The measure of loss from market risk stress tests could in principle is used as a soundness indicator along with, or even in place of, market risk FSIs. As a final point, FSIs of banking sector liquidity monitor liquid assets available to banks in the event of a loss of market funding or of deposits in a bank run. The FSI of liquid assets to total assets, also termed the liquidity ratio, reveals how vulnerable the banking sector is to a liquidity crisis by indicating how much balance sheet shrinkage it could absorb due to a loss of access to funding or a bank run before being forced to sell illiquid assets. The FSI of liquid assets to short-term liabilities measures liquid assets relative to short-term liabilities that would have to be covered by asset sales if access to market funding is lost. FSIs of market liquidity monitor current liquidity conditions in markets for each of the main types of securities that make up the liquid assets of the banking sector. Table 1: Financial Soundness Indicators: Core Set Capital adequacy Regulatory capital to risk-weighted assets Regulatory Tier I capital to risk-weighted assets Asset quality Nonperforming loans to total gross loans Nonperforming loans net of provisions to capital Sectoral distribution of loans to total loans Large exposures to capital Earnings and profitability Return on assets

Return on equity Interest margin to gross income Noninterest expenses to gross income Liquidity Liquid assets to total assets (liquid asset ratio) Liquid assets to short-term liabilities Sensitivity to market risk Duration of assets Duration of liabilities Now we reveal the financial soundness indicators for Bangladesh, India and Pakistan and to locate our standing means where we are according to others! Table 2: State of Financial Soundness: Bangladesh India and Pakistan Table 2 shows that over the year, Bangladesh financial position of Bangladesh banking system has improved but still generally behind relative to regional comparators. Stress testing: Basel Proposal Basle document (Jan 96) spells out stress testing as one of the prerequisites for internal model approval Capital viewed as the last line of defense in a bank. When risk management is insufficient, when reserves are exhausted, capital absorbs losses to prevent a banks failure. But when capital runs out, the bank may become insolvent, leaving public authorities and taxpayers responsible for restoring depositors savings. Basel stands on Three Basic Pillars, first of all Minimum Capital Requirement which provide an economic incentive - in the form of lower capital charges. For those banks that develop better measures for their exposures to risk and better techniques for managing their risks. The second strong pillar is Supervisory Review Process which are use to evaluate, how bank performs internal processes for risk management. Supervisors check that parameters and conditions used to evaluate risk measures are sound and rigorous. Finally, market discipline requirements, the third pillar seeks to leverage the ability of markets to provide discipline to Indicators 2004 2005 2006 2007
BNG IND PAK BNG IND PAK BNG IND PAK BNG IND PAK

Risk weighted capital asset ratio

6.9 12.8 10.5 7.3 12.3 11.3 5.3 12.3 12.7 7.4 12.6 13.7

Gross NPL ratios

17.6 5.2 11.6 13.5 3.3 8.3 13.1 2.5

6.9 13.2 2.8 7.4

Provisions as proportion of NPLs

19.1 61.5 70.4 24.3 63.6 76.7 26.3 40.0 77.8 42.9 42.8 74.7

Net NPL
14.0 2 3.4 10.1 1.2 1.9 9.5 1 1.5 7.5 1.2 1.8

Return on asset
0.7 0.9 1.2 0.6 0.9 1.9 0.8 0.9 2.1 0.9 1 2.0

banks to ensure that they are not holding unrealistically low levels of capital. Hence, banks perform stress tests to ensure banks capital adequacy in times of shocks. Now the challenge is determining how much capital is sufficient?Stress testing is considered to be an effective and necessary tool that complements statistical models for quantifying & monitoring risk and capital adequacy By its very nature, stress testing also sets a high qualitative and quantitative standard for risk management. Why Stress Testing? Supervisory & Banks Expectations: What does the regulator hope to achieve? What does the bank hope to achieve?

Able to understand mechanism through which stress develops.

Able to implement measures when the effects of stress events evolve into a vicious circle involving the real economy, financial markets and the banking sector.

Identify where the risk concentrations are?

Understand impact on bank if biggest customers default?

Impact on bank if historical worst-case scenarios recur?

Impact on bank if it is hit by a similar severe credit loss event that affected competitors in the past? The Stress Events Occur Anytime, Sometimes Unexpectedly. Negative macroeconomic environment can create the urgent situation for banks to test their financial fitness. Another sources of crisis like Oil crisis, high exchange rate, large current account deficit, political & social instability, Bali bombing, SARS outbreak, general election, or impact of worlds largest market, US Enron, dotcom bust, post-Sept. 11, or lack of market transparency, analyst & IPO scandal, unexpected risk from impact of insider trading, opaque corporate governance, post- irrational exuberance, fear & investor panic leading to short-term funds outflow after bubble burst etc. are the main sources of banks crisis.
The PRI (Policy Research Institute) Basic Guidelines for SEB (South East Bank) Stress

Testing: I. Relevance depending on the size and sophistication of institutions: The Guidelines on stress testing will be applied for SEB based on its size, sophistication and diversification. II. Stress testing coverage:

SEB should identify their material risks. In general, SEB should conduct adequate and proportionate stress tests on all the risks they have identified as material. III. Stress testing calibration: Based upon the identification of material risks, SEB should derive material risk drivers that should be subject to stress testing. Depending on their situation, SEB should consider historical and/or hypothetical scenarios. Stress testing should be based on exceptional but plausible events. Stress testing should in principle be applied at the same level as the internal capital adequacy assessment process (ICAAP). IV. Frequency and time horizon of stress testing: The frequency of stress testing should be determined in accordance with the nature of the risks to which the SEB is exposed and the type of tests performed. SEB should determine the time horizon of stress testing in accordance with the maturity and liquidity of the positions stressed where applicable.

Under specific circumstances, supervisors may require institutions to perform ad hoc stress tests at a specific point in time. V. Data quality and IT systems: SEB should use appropriate and representative data when performing stress tests and the IT resources should be commensurate with the complexity of the techniques and the coverage of stress tests performed by SEB. VI. Role of the management body and senior management; reporting and interpretation of stress testing results: The SEB management body has the ultimate responsibility for the overall stress testing framework. Where appropriate the SEB management body can delegate certain aspects of this framework to specific risk committees or senior management, keeping the effective oversight. The stress testing process should be an integral part of the SEB risk management framework, with clear reporting lines and communication in an understandable format. Where deemed appropriate by the SEB, it should take remedial measures or actions considering the level of risk exposure as revealed by stress tests and the objectives and risk tolerances defined by the management body. Appropriate documentation should be in place to facilitate the adequate implementation of the whole stress testing framework. VII. Review and update of stress testing methodology:

SEB should consider periodically whether stress tests are still adequate. In particular, SEB