About Stress Testing

Stress Testing is an integral part of a bank's risk measurement system and plays an important role in estimating the effects of potential financial crises on a bank's operations. Stress Testing or Risk Estimation Technique refers to the process of examining the stability of a system or entity in adverse conditions. It involves testing beyond normal operational capacity, often to a breaking point, to observe the results. It also helps banks analyze to estimate the impact of movements in the variables on specific measures such as profitability and capital adequacy.

The Stress Testing utility supports the stress testing requirements across the entire suite of OFSAA products. It allows banks to define shocks and assess the impact of such shocks across multiple business areas.

The commonly accepted forms of Stress Testing are:

• Sensitivity Analysis: Shocks are applied to a single variable.
• Scenario Analysis: A scenario is defined as a shock to a single variable or a collection of shocks on multiple variables. Scenario analysis involves applying simultaneous shocks on multiple variables to assess the impact of the scenario on a measure or a set of measures. Scenarios are further classified into the following categories:
  • Historical Scenarios:These scenarios replicate past events docket. They are defined by specifying shocks to variables such that they replicate the movement seen during historical events.

    For example, the user may define a scenario that replicates the movement in stock market indices as observed during the catastrophic event. This scenario can then be applied to the current trading book portfolio of the bank to estimate the loss that might be incurred if a catastrophic event occurs. However, the historical scenarios may not cover the entire range of potential adverse conditions.

  • Hypothetical Scenarios:These scenarios are based on user judgment and address the other possible adverse movements in the variables.

Figure 10-1 Stress Testing Workflow