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1 Stress Testing
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
1.2 Stress Testing Methodologies
In term of methodologies, stress tests can be broadly classified into following two types:
1.2.1 Sensitivity Analysis
Sensitivity Analysis typically examines the short term impact of change in some variable
interest rate, equity prices or a combination of both on the value of a portfolio/financial
position.
For instance, sensitivity tests may include (i) a parallel shift in the yield curve by 200 basis
points (ii) depreciation of domestic currency by 15% and (iii) increase in consumer loan
defaults by 30%.
While the simplicity of sensitivity analysis makes it easier to use and understand, at best ,it
provides an approximation of the impact of a risk factor on a portfolio. Such analysis does not
take into account the reason behind the movement of a selected risk factor or the
probability of occurrence of any such movement.
Potentially, a number of variables can be collectively stressed or different sensitivity test can
be combined to form a multifactor stress test. For instance, the worst ever movement in equity
price ,interest rates over the past 10 years can be combined to form a multifactor shock.
However, this approach still ignores the correlation between risk factors and should be
interpreted accordingly. The time horizon for sensitivity analysis is often shorter, usually
instantaneous. These tests can be designed on the basis of historical or hypothetical
movements in risk factors.
1.2.2 Scenario Analysis
Scenario Analysis assesses impact of extreme but plausible scenarios on a given portfolio/
financial position of an institution, using sophisticated modeling techniques and typically
incorporating macroeconomic variables. Scenarios could be historical (events experienced in
the past like stock market crashes, currency depreciations or natural disasters) or
hypothetical (plausible events that are extreme but not improbable). At the supervisory level,
scenario analysis has been extended to contagion analysis with the objective of examining the
transmission of shocks from individual institutions to the system as a whole. Macro stress
testing in particular has become very popular among supervisors as a tool to assess
vulnerabilities of the overall financial system. Moreover, leading financial institutions use macro
stress testing mostly in conjunction with their internal risk models of credit risk. Scenario analysis
takes into account correlations between risk factors, including macroeconomic variables.
Shocks assumed are closer to real life as other factors are not supposed to be held constant ‐
a big assumption under simple sensitivity test. However, the complexity of various techniques
based on statistical/macroeconomic modeling has somewhat restricted its usage to banks with
sophisticated risk management systems.
Provides a useful base for communication of key risks across the organization;
Supplements other risk measures by providing a complementary perspective on various
risks;
Indicates how much capital might be needed to absorb losses if worst‐case scenarios
materialize
Provides forward looking assessment of risks and facilitates capital allocation and liquidity
management.
Helps development of risk mitigation or contingency plans across a range of stress conditions
Enables management to set limits for risk tolerance and redesign their risk strategies if REQ
Adds value to the risk analysis when combined with other statistical measures like value‐at‐
risk models by particularly focusing on tail events;
Highlights the limitations of models and historical data by exhibiting the impact of extreme y
et plausible shocks which models using normal conditions fail to capture; and
B. Liabilities maturing within 1 month minus Assets maturing within 1 month (based on
Banks should calculate after-shock LCR by using each of the following three scenarios:
(i) Applying 20% haircut to the value of Investments in Government Securities while
(iii) Applying 20% haircut to the value of Investments in Government Securities while
calculating “A” component of the ratio and increasing the denominator “max (B, C)”
by 20%.
Scenario CR-4:
Calculation of Default Rate:
Credit Risk Scenario‐4 (CR‐4) stresses the default rate of a corporate portfolio and gauges its
impact on capital adequacy ratio of a bank. For this shock, the Default Rate shall be defined
as follows:
For the shock C4, the default rate is defined as a ratio of amount of outstanding ex
posure that defaulted (as per definition above) to the total amount of exposure that
could potentially default during a specified period of time.
Formula to Calculate Quarterly Default Rate:
Following formula should be used to calculate quarterly default rate using outstanding
exposures of the borrowers:
Scenario IR-1:
Change in Net Interest Income (NII) using Repricing Gap:
Annexure -B
Scenario IR‐1:
Change in Net Interest Income (NII) using Repricing Gap:
Annexure ‐B
The repricing gap is the difference between the rate sensitive assets (RSA) and rate sensitive
liabilities (RSL) for a particular time band. The change in net interest income
(NII) can be estimated using the repricing gaps.
A bank with more rate sensitive assets than rate sensitive liabilities would have
positive repricing gap thus with any increase in interest rates there will be an increase in net
interest income. Accordingly, a financial institution with more rate sensitive liabilities than rate
sensitive assets would be negatively gapped, and in case, of increase in the
interest rates there will be a decrease in net interest income.
Change in NII of a bank/DFI due to changes in interest rates can be calculated by using the
following formula:
∆NII = GAP * ∆R
where GAP= (RSA – RSL)
Duration
A maturity/repricing schedule can also be used to evaluate the effects of changing interest rates on a
bank's economic value by applying sensitivity weights to each time band. Typically, suchweights are
based on estimates of the duration of the assets and liabilities that fall into each time band. Duration
is a measure of the percentage change in the economic value of a position thatwill occur given a
small change in the level of interest rates.
It reflects the timing and size of cash flows that occur before the instrument's contractual maturity.
Generally, the longer the maturity or next repricing date of the instrument and the smaller the
payments that occur before maturity (e.g. coupon payments), the higher the duration (in absolute
value). Higher duration implies that a given change in the level of interest rates will have a larger
impact on economic value.
Duration-based weights can be used in combination with a maturity/repricing schedule to provide a
rough approximation of the change in a bank's economic value that would occur given a particular
change in the level of market interest rates. Specifically, an “average” duration is assumed for the
positions that fall into each time band. The average durations are then multiplied by an assumed
change in interest rates to construct a weight for each time band. In some cases, different weights
are used for different positions that fall within a time band, reflecting broad differences in the
coupon rates and maturities (for instance, one weight for assets, and another for liabilities). In
addition, different interest rate changes are sometimes used for different time bands, generally to
reflect differences in the volatility of interest rates along the yield curve. The weighted gaps are
aggregated across time bands to produce an estimate of the change in economic value of the bank
that would result from the assumed changes in interest rates. Alternatively, an institution could
estimate the effect of changing market rates by calculating the precise duration of each asset,
liability, and OBS position and then deriving the net position for the bank based on these more
accurate measures, rather than by applying an estimated average duration weight to all positions in
a given time band. This would eliminate potential errors occurring when aggregating positions/cash
flows. As another variation, risk weights could also be designed for each time band on the basis of
actual percentage changes in market values of hypothetical instruments that would result from a
specific scenario of changing market rates. That
approach - which is sometimes referred to as effective duration - would better capture the
nonlinearity of price movements arising from significant changes in market interest rates and,
thereby, would avoid an important limitation of duration.
Estimates derived from a standard duration approach may provide an acceptable approximation of a
bank's exposure to changes in economic value for relatively non-complex banks. Such estimates,
however, generally focus on just one form of interest rate risk exposure - repricing risk. As a result,
they may not reflect interest rate risk arising, for instance, from changes in the relationship among
interest rates within a time band (basis risk). In addition, because such approaches typically use an
average duration for each time band, the estimates will not reflect differences in the actual
sensitivity of positions that can arise from differences in coupon rates and the timing of payments.
Finally, the simplifying assumptions that underlie the calculation of standard duration means that
the risk of options may not be adequately captured.
B. Simulation approaches
Many banks (especially those using complex financial instruments or otherwise having complex risk
profiles) employ more sophisticated interest rate risk measurement systems than those basedon
simple maturity/repricing schedules. These simulation techniques typically involve detailed
assessments of the potential effects of changes in interest rates on earnings and economic value
by simulating the future path of interest rates and their impact on cash flows.
2. Dynamic simulation
In a dynamic simulation approach, the simulation builds in more detailed assumptions about the
future course of interest rates and the expected changes in a bank's business activity over that time.
For instance, the simulation could involve assumptions about a bank's strategy for changing
administered interest rates (on savings deposits, for example), about the behaviour of the bank's
customers (e.g. withdrawals from sight and savings deposits), and/or about the future stream of
business (new loans or other transactions) that the bank will encounter. Such simulations use these
assumptions about future activities and reinvestment strategies to project expected cash flows and
estimate dynamic earnings and economic value outcomes. These more sophisticated techniques
allow for dynamic interaction of payments streams and interest rates, and better capture the effect
of embedded or explicit options. As with other approaches, the usefulness of simulation-based
interest rate risk measurement techniques depends on the validity of the underlying assumptions
and the accuracy of the basic methodology. The output of sophisticated simulations must be
assessed largely in the light of the validity of the simulation's assumptions about future interest rates
and the behaviour of the bank and its customers. One of the primary concerns that arises is that
such simulations do not become “black boxes” that lead to false confidence in the precision of the
estimates.
One of the most difficult tasks when measuring interest rate risk is how to deal with those positions
where behavioural maturity differs from contractual maturity (or where there is no stated
contractual maturity). On the asset side of the balance sheet, such positions may include mortgages
and mortgage-related securities, which can be subject to prepayment. In some countries, borrowers
have the discretion to prepay their mortgages with little or no penalty, which creates uncertainty
about the timing of the cash flows associated with these instruments. Although there is always some
volatility in prepayments resulting from demographic factors (such as death, divorce, or job
transfers) and macroeconomic conditions, most of the uncertainty surrounding prepayments arises
from the response of borrowers to movements in interest rates. In general, declines in interest rates
result in increasing levels of prepayments as borrowers refinance their loans at lower yields. In
contrast, when interest rates rise unexpectedly, prepayment rates tend to slow, leaving the bank
with a larger than anticipated volume of mortgages paying below current market rates. On the
liability side, such positions include so-called non-maturity deposits such as sight deposits and
savings deposits, which can be withdrawn, often without penalty, at the discretion of the depositor.
The treatment of such deposits is further complicated by the fact that the rates received by
depositors tend not to move in close correlation with changes in the general level of market interest
rates. In fact, banks can and do administer the rates on the accounts with the specific intention of
managing the volume of deposits retained. The treatment of positions with embedded options is an
issue of special concern in measuring the exposure of both current earnings and economic value to
interest rate changes. In addition, the issue arises across the full spectrum of approaches to interest
rate measurement, from simple gap analysis to the most sophisticated simulation techniques. In the
maturity/repricing schedule framework, banks typically make assumptions about the likely timing of
payments and withdrawals on these positions and “spread” the balances across time bands
accordingly. For instance, it might be assumed that certain percentages of a pool of 30-year
mortgages prepay in given years during the life of the mortgages. As a result, a large share of the
mortgage balances that would have been assigned to the time band containing 30-year instruments
would be spread among nearer-term time bands. In a simulation framework, more sophisticated
behavioural assumptions could be employed, such as the use of option-adjusted pricing models to
better estimate the timing and magnitude of cash flows under different interest rate environments.
In addition, simulations can incorporate the bank's assumptions about its likely future treatment of
administered interest rates on non-maturity deposits. As with other elements of interest rate risk
measurement, the quality of the estimates of interest rate risk exposure depends on the quality of
the assumptions about the future cash flows on the positions with uncertain maturities. Banks
typically look to the past behaviour of such positions for guidance about these assumptions. For
instance, econometric or statistical analysis can be used to analyse the behaviour of a bank's
holdings in response to past interest rate movements.Such analysis is particularly useful to assess
the likely behaviour of non-maturity deposits, which can be influenced by bank-specific factors such
as the nature of the bank's customers and local or regional market conditions. In the same vein,
banks may use statistical prepayment models -either models developed internally by the bank or
models purchased from outside developers – to generate expectations about mortgage-related cash
flows. Finally, input from managerial and business units within the bank could have an important
influence, since these areas may be aware of planned changes to business or repricing strategies
that could affect the behaviour of the future cash flows of positions with uncertain maturities.
5.2 In order to assign obligor ratings the banks are required to consider, but not
b. Leverage
c. Profitability
d. Cash flows
a. Ownership structure
d. Strength of Sponsors
C. Qualitative factors:
a. CIB report
b. Sector of business
D. Others:
a. Country risk
5.3 In order to assign the facility ratings, the bank should consider the relevant and material
information including :
A. Facility
b. Loan structure
c. Product type
d. Priority of rights in case of bankruptcy
e. Degree of collateralization
f. Composition of collateral
B. Collateral
a. Nature
b. Quality
c. Liquidity
d. Market value
h. Legal enforceability
5.4 In the case of credits to individuals, factors such as personal income, wealth, debt burden and
other relevant personal information should also be considered.
11.1 All banks and DFIs are required to develop their internal risk rating policy duly approved by
their Board of Directors and formulate their internal risk rating systems based on the two tier rating
system as mentioned earlier. The policy should provide for objective criteria for grading of the
exposures on the rating scales for both borrower and facility ratings. The criteria should be clear and
well documented.
11.2 In order to effectively manage their credit portfolios, banks may have as many credit grades as
they wish. However, for reporting purpose to the State Bank, banks are required to map their
borrower ratings in nine performing categories i.e. 1 to 9 and three default categories i.e. 10 to 12.
For facility ratings banks are required to map their ratings to six facility rating grades i.e. A to F
showing expected zero loss to full exposure loss.
11.3 These regulatory grades are broadly defined in the Annexure A. The mapping should be based
on the given definitions and the bank’s internal definitions of credit ratings.
11.4 All banks DFIs are advised to submit the borrower’s ratings in the field IBRATING and facility
rating in the field (to be informed later) in their credit information reports submitted in eCIB.
Annexure A
The banks are required to establish criteria to map their internal obligor ratings according to the
broad definitions provided below:
The rating grade 1 means that the credit exposure is of the highest quality and has minimum credit
risk. This rating should be assigned only when the creditor’s capacity and willingness to meet its
financial obligations in time is extremely strong and is unlikely to be adversely affected by the
economic or foreseeable events.
The rating grade 2 should be assigned to very good quality creditors that are lower than grade 1 in
only small degree and denotes somewhat larger credit risk than grade 1creditors. This distinction
may be based on the facts which lead to show that the margins of protections may not be as large as
in the highest quality grade or there are other elements present which make the long term risk
appear somewhat larger. The obligor’s capacity to meet its financial commitment on the obligation is
very strong and is not significantly vulnerable to foreseeable events.
The rating scale 3 should be assigned to good quality creditors, whose capacity to meet their
financial commitment to the obligation is still strong, however there are elements present, however
minor, which may suggest a susceptibility to impairment some time in the future. This category is
more susceptible to adverse effects of changes in circumstances and economic conditions than
obligations in higher rated categories.
The rating grade of 4 should be assigned to medium quality obligor and bears average security and
certainty of timely fulfillment of financial obligations. Although capability and willingness of the
obligor are adequate however, certain protective elements may be lacking or may be
characteristically unreliable over any greater length of time. Although adequate protection
parameters are present yet, adverse economic conditions or changing circumstances are more likely
to lead to a weakened capacity of the obligor to meet its financial commitment to the obligation.
The rating grade of 5 should be assigned to the lower medium quality obligor, whose future cannot
be considered as well assured. Such customers bear high risk associated with their capability or
willingness to fulfill their financial obligations in a timely manner and face major uncertainties or
exposure to adverse business, financial or economic variations which could lead to their inadequate
capacity to meet financial commitment.
The rating grade of 6 means poor quality creditors. Fulfillment of financial obligations over any
longer period of time may be uncertain. Although the obligor currently has the capacity and
willingness to meet its financial obligations, yet is more vulnerable to non payment than obligations
rated 5. Capacity for continued payment is contingent on a sustained, favorable business, financial
and economic conditions. Even non-distinct variations in the business, financial or economic
conditions will likely impair the obligor’s capacity or willingness to meet its financial commitment on
the obligation.
The obligors graded 7 are of poor standing and there may be elements of danger with respect to
fulfillment of their financial obligations. They are currently vulnerable to nonpayment, and their
capability to meet financial obligations is dependent upon favorable business, financial, and
economic conditions. Very high risk factors are present and negative variations of business, financial
and economic conditions of any scope mean real risk of default.
The rating grade of 8 means that the capacity of the obligor to meet its financial commitments is
currently highly vulnerable and at any time may discontinue its payments. Its capability to meet its
financial obligations depends on distinctively positive development of the sector and industry of the
operation of the obligor.
The obligor bears the highest default risk exposure and is virtually in default but payments on the
obligations are still continued. Even the positive development of the business, financial and
economic conditions need not mean its capability to meet its financial obligations.
Facility Grades
Facility grades should be assigned according to the severity of the expected losses in case of default,
keeping in view the factors listed above. For reporting purposes the definitions of the facility grades
would be:
Facility grade A would represent the facilities where severity of loss would be minimal
and close to zero in case of default. In other words the bank is expected to recover almost whole of
the principal and interest and other outstanding charges.
Facility grade B would represent that the severity of loss in case of default is mild and bank would be
able to recover most of its principal and interest in case obligor defaults.
Facility grade C would represent the facilities where the severity of loss is medium.
Facility grade D would be assigned to the facilities where the expected loss of principal and interest
would be high.
Facility grade E means that the expected loss would be very high.
Facility grade F shows that the loss severity would be highest in case of default and bank may not
recover all the principal or interest.
Broadly the facility grades listed above would represent the following expected recovery rates as a
percentage of outstanding exposure.