Principle for sound stress testing

Original by Bank of England, 2014, web pages 

This summary note was Posted on

15 points from « principle for sound stress testing »

Use of stress testing and integration in risk governance

  1. Stress testing should form an integral part of the overall governance and risk management culture of the bank. Stress testing should be actionable, with the results from stress testing analyses impacting decision making at the appropriate management level, including strategic business decisions of the board and senior management. Board and senior management involvement in the stress testing programme is essential for its effective operation.
  2. A bank should operate a stress testing programme that promotes risk identification and control; provides a complementary risk perspective to other risk management tools; improves capital and liquidity management; and enhances internal and external communication.
  3. Stress testing programmes should take account of views from across the organisation and should cover a range of perspectives and techniques.
  4. A bank should have written policies and procedures governing the stress testing programme. The operation of the programme should be appropriately documented.
  5. A bank should have a suitably robust infrastructure in place, which is sufficiently flexible to accommodate different and possibly changing stress tests at an appropriate level of granularity.
  6. A bank should regularly maintain and update its stress testing framework. The effectiveness of the stress testing programme, as well as the robustness of major individual components, should be assessed regularly and independently.

Stress testing methodology and scenario selection

  1. Stress tests should cover a range of risks and business areas, including at the firm-wide level. A bank should be able to integrate effectively, in a meaningful fashion, across the range of its stress testing activities to deliver a complete picture of firm-wide risk.
  2. Stress testing programmes should cover a range of scenarios, including forward-looking scenarios, and aim to take into account system-wide interactions and feedback effects.
  3. Stress tests should feature a range of severities, including events capable of generating the most damage whether through size of loss or through loss of reputation. A stress testing programme should also determine what scenarios could challenge the viability of the bank (reverse stress tests) and thereby uncover hidden risks and interactions among risks.
  4. As part of an overall stress testing programme, a bank should aim to take account of simultaneous pressures in funding and asset markets, and the impact of a reduction in market liquidity on exposure valuation.
  5. The effectiveness of risk mitigation techniques should be systematically challenged.
  6. The stress testing programme should explicitly cover complex and bespoke products such as securitised exposures. Stress tests for securitised assets should consider the underlying assets, their exposure to systematic market factors, relevant contractual arrangements and embedded triggers, and the impact of leverage, particularly as it relates to the subordination level in the issue structure.
  7. The stress testing programme should cover pipeline and warehousing risks. A bank should include such exposures in its stress tests regardless of their probability of being securitised.
  8. A bank should enhance its stress testing methodologies to capture the effect of reputational risk. The bank should integrate risks arising from off-balance sheet vehicles and other related entities in its stress testing programme.
  9. A bank should enhance its stress testing approaches for highly leveraged counterparties in considering its vulnerability to specific asset categories or market movements and in assessing potential wrong-way risk related to risk mitigating techniques.

Reverse stress tests

Banks, building societies, insurers and some BIPRU investment firms are also required to undertake ‘reverse stress tests’.

Reverse stress-tests are stress tests that require a firm to assess scenarios and circumstances that would render its business model unviable, thereby identifying potential business vulnerabilities. This differs from general stress and scenario testing, which tests for outcomes arising from changes in circumstances.  A firm’s business model is described as being unviable at the point when crystallising risks cause the market to lose confidence in the firm.

Reverse stress-testing is primarily designed to be a risk management tool, encouraging firms to explore more fully the vulnerabilities and fault lines in its business model, including ‘tail risks’, and to explore potential mitigating actions.

The PRA works with counterparts in the EU and internationally on approaches to stress-testing.