A Half-day Workshop on
“Stress Testing”
(A Tool of Risk Management)
Held at Learning Resource Centre, SBP
November 23, 2006
Conducted by:
Mr. Muhammad Akhtar Javed, Joint Director-BSD
Ms. Rizwana Rifat, Assistant Director-BSD
STATE BANK OF PAKISTAN
SBP
Outline
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Stress Testing
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Meaning of Stress Testing
Why need stress Testing
Uses of Stress Testing
Main Guidelines Underpinning Sound Stress
Testing by Institutions
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Relevance Depending on Size and Sophistication of Institutions
Stress Testing Coverage
Stress Testing Calibration
Frequency and Time Horizon of Stress Testing
Data Quality and IT Systems
SBP
Outline – Continued...
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Main Guidelines …..
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Stress Testing Guidelines by Risk Categories
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Role of Management Body and Senior Management
Review and Update of Stress Testing Methodology
Macroeconomic Stress Tests
Market Risk
Credit Risk
Liquidity Risk
Consideration for Other Risk Categories
SBP
Outline – Continued...
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Stress Testing Guidelines Issued by SBP

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Scope
Level of Shocks
Methodology
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Interest Rate Risk
Exchange Credit
Equity
Liquidity
SBP
Outline – Continued...
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Stress Testing Guidelines Issued by SBP….
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Reporting Format
What is required from Banks
Road to future
Stress Test Results
International Experiences
SBP
Stress Testing- Meaning
As defined by the BIS, stress testing is a risk
management technique used to evaluate the
potential effects on an institution’s financial
condition of a specific event and/or movement in
a set of financial variables. The traditional focus of
stress testing relates to exceptional but plausible
events.
SBP
Why Need Stress Tests
Stress testing is :

Risk management tool
Helps in assessment of the risks
 Quantifies the resilience towards shock events
 Helps manage the shock results


Required by the Capital Directive…Basel II
rigorous program of stress testing
 periodic stress tests of the credit risk concentrations
 the realization of collateral in stressed situations
 stress testing processes for use in the assessment of its capital
adequacy…. etc.

SBP
Uses of Stress Testing

As a diagnostic tool to improve the institution’s
understanding of its risk profile.
Earnings are a part of an institution’s overall capital planning and are
the first line of defense to absorb losses. Therefore, institutions
should, in the context of their internal capital adequacy assessment
process (ICAAP), assess how their earnings are affected by stress
situations.

As a forward looking tools
Stress testing may be used to assess the adequacy of internal capital.
SBP
Types of Stress Testing
Stress testing could generally fall within the following
two categories and concepts: scenario tests and
sensitivity analyses.


Sensitivity analyses are generally less complex to carry out
since they assess the impact on an institution's financial
condition of a move in one particular risk factor, the source
of the shock not being identified.
Whereas scenario tests tend to consider the impact of
simultaneous moves in a number of risk factors, the stress
event being well defined.
SBP
Main Guidelines Underpinning Sound Stress
Testing by Institutions
Relevance depending on the size and sophistication
of institutions
•As a general rule, sophisticated institutions should use a
combination of both scenario tests and sensitivity analysis
whereas less complex institutions may develop a less technically
demanding approach.
•Scenarios with greater coverage across product lines or geographical
regions, and considering secondary effects, may be rather employed
by large and complex institutions.
SBP
Main Guidelines Underpinning Sound Stress
Testing by Institutions…
Stress testing coverage
Institutions should identify their material risks.
The main areas which institutions have considerable exposure to (e.g.
where they are an active market maker) should be the ones most
thoroughly captured under a stress testing framework. Institutions
should thus determine all material risks that can be subject to stress
testing.
The identification of material risks could stem from:
•a comprehensive review by institutions of the nature and
composition of their portfolios.
•a review of the external environment in which institutions are
operating with a view to assessing the extent that this could affect
their financial condition.
SBP
Main Guidelines Underpinning Sound Stress
Testing by Institutions…
Stress testing calibration
Based upon the identification of material risks, institutions
should derive material risk factors that should be subject to
stress testing.
Institutions should first identify their points of vulnerability in
order to stress the relevant risk factors that may affect their
earnings/profitability or solvency.
With this in mind, an analysis of past losses can provide
valuable information.
The number of risk factors to be stressed should depend on
the complexity of the portfolio and the risks the institution is
exposed to.
SBP
Main Guidelines Underpinning Sound Stress
Testing by Institutions…
Frequency and time horizon of stress testing
•the nature of the risk factors captured under the stress
testing framework, and in particular their volatility.
•the techniques used by institutions while performing stress
tests.
•significant changes in the external environment or in the risk
profile of institutions.
•the availability of the external data required to conduct the
stress tests (for instance, data necessary to perform
macroeconomic stress tests).
SBP
Main Guidelines Underpinning Sound Stress
Testing by Institutions…
Frequency and time horizon of stress testing
•Institutions should determine the time horizon of stress
testing in accordance with the maturity and liquidity of
the positions stressed.
•Under specific circumstances, supervisors may require
institutions to perform ad hoc stress tests at a specific point
in time.
SBP
Main Guidelines Underpinning Sound Stress
Testing by Institutions…
Data quality and IT systems
Institutions should use accurate, complete, 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
institutions
SBP
Main Guidelines Underpinning Sound Stress
Testing by Institutions…
Role of the management body and senior management;
reporting and interpretation of stress testing results
•The management body has the ultimate responsibility for the
overall stress testing framework. Where appropriate the
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 an
institution’s risk management framework, with clear reporting
lines and communication in an understandable format.
SBP
Main Guidelines Underpinning Sound Stress
Testing by Institutions…
Review and update of stress testing methodology
Institutions should consider periodically whether stress tests are
still adequate. In particular, institutions should ensure that
assumptions regarding the risk profile and the external
environment are still valid over time .
This assessment should cover in particular:
the scope of exposures captured under the stress testing process,
•· the validity of the assumptions,
•· the adequacy of the management information system,
SBP
Main Guidelines Underpinning Sound Stress
Testing by Institutions…
Review and update of stress testing methodology
•· the integration into the institution’s management processes, including
the clarity of reporting lines,
•· the approval policy of the stress testing process (including in case of
changes),
•· the reliability, accuracy and completeness of data incorporated into
the stress testing process, and
•· the quality of the documentation of the stress testing process.
SBP
Stress testing guidelines by risk categories
Macroeconomic stress tests
In doing so, an institution should consider the effects of
macroeconomic factors on its capital and whether it could affect its
strategic plans.
Market Risk
•Interest rate
•Exchange rate
•Equity Price
Credit risk stress testing
•Concentration Risk
Liquidity risk
SBP
Considerations for other risk categories
If the level of risk of a specific category is material enough to
make the institution vulnerable with respect to this risk, the
institution has to take the risk into account when assessing the
adequacy of its internal capital. However, some risks are more
qualitative in nature and therefore cannot be measured exactly.
•some kinds of operational risk (e.g. legislative risk),
•reputational risk or strategic risk.
Stress Testing Guidelines
Issued by SBP
SBP
Scope of Stress Test

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Limited to “Simple Sensitivity Analysis”
Risk factors identified
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Interest rate
Non-performing loans
Forced sale value of collateral
Stock prices
Foreign exchange rate
For liquidity risk, shock has been given to the liquid
liabilities (deposits and borrowings)
SBP
Level of Shocks
Risk Factors
Increase in Interest Rate
Adverse movement in Exchange
Rate
Increase in NPLs
Downward Shift in NPLs categories
Fall in the FSV of Collateral
Fall in the value of Equity
Exposure
Fall in Liquid Liabilities
Minor
Moderate Major
1%
5%
2%
10%
5%
15%
5%
50%
10%
10%
10%
80%
20%
20%
20%
100%
40%
40%
10%
20%
30%
SBP
Methodology
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Interest Rate Risk
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Duration GAP analysis
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Estimate the MV of all the RSA and RSL to arrive at market
value of equity
Calculate the duration of all the assets and liabilities
Arrive at the weighted average duration of assets and liabilities
Calculate duration GAP and estimate the changes in the
economic value of equity along different interest rate changes
Calculate surplus (deficit) on off-balance sheet items along
different interest rate changes
Estimate the impact of the net change (on-balance sheet plus offbalance sheet) in the economic value of equity on the capital
adequacy ratio
SBP
Methodology

Exchange Rate Risk
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Simple shocks to Net Foreign Currency Position


Overall net open position is to be measured by aggregating the
sum of net short positions or sum of net long positions,
whichever is greater irrespective of sign
The impact of the respective shocks will be calibrated in terms
of capital adequacy ratio
SBP
Methodology
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Credit Risk
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Involves three types of shocks
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Increase in NPLs by 5%, 10% and 20% and directly
downgraded to loss category
Shift in NPLs categories by 50%, 80% and 10%
Fall in the forced sale value of mortgaged collateral by 10%,
20% and 40%
Tax-adjusted impact of each scenario will be calibrated
in capital adequacy ratio
SBP
Methodology

Equity Price Risk

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Simple shocks to the market value of listed shares,
NIT units and mutual funds etc. by 10%, 20% and
40%
The impact of resultant loss will be calibrated in the
CAR
SBP
Methodology
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Liquidity Risk
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Simple shocks to the liquid liabilities (deposits and
borrowings)
Impact is calibrated in liquid assets to liquid liabilities
ratio
Comfortable level of ratio after shock is considered at
30%
SBP
Reporting Format
Please see the Reporting Format on the Following
Link:
Stress Testing Reporting Format
SBP
What’s Required from Banks and DFIs
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
Establishing an organizational set-up for regular
stress testing
Carrying out and submit to SBP stress test on halfyearly basis in line with these guidelines
SBP
Road to Future

With the increasing know how and availability of
more data the model will over time undergo further
refinement
SBP
BOX - 6.1
Reference Scenarios
Credit Shocks
Scenario C-1 assumes a 10 percent increase in NPLs (with a provisioning rate of 100 percent).
Scenario C-2 assumes a withdrawal of benefit of FSV against NPLs.
Scenario C-3 assumes a cumulative impact of the two shocks under Scenarios C-1 and C-2.
Scenario C-4 assumes an increase in NPLs equivalent to 5 percent of gross advances (with a
provisioning rate of 50 percent for additional NPLs).
Scenario C-5 refers to the NPLs to total loans ratio, which would wipe out capital (with a 50 percent
provisioning rate for additional NPLs).
Market Risk: Interest Rate Shocks
Scenario IR-1 assumes an increase in interest rates by 200 basis points.
Scenario IR-2 assumes an increase in interest rates of outlying maturities (by 0, 100, and 150 basis
points)
Scenario IR-3 assumes a shift coupled with flattening of the yield curve by increasing 150,100 and 50
basis points in the three maturities respectively.
Market Risk: Exchange Rate Shocks
Scenario ER-1 assumes a depreciation of ER by 25 percent (around double of the change in the
monthly average PKR/US$ exchange rate (12.83) over the period from Jan 1994 to Dec 2005, in
September 2000).
Scenario ER-2 is based on the hypothetical assumption of appreciation of rupee by 10 percent.
Scenario ER-3 assumes a 10 percent depreciation of the rupee and deterioration in the quality of 10
percent of unhedged foreign currency loans with 50 percent provisioning requirement.
Market Risk: Equity Price Risk Shocks
Scenario E-1 assumes the impact of a 20 percent decline in the Stock Market Index.
Scenario E-2 assumes the impact of a 40 percent decline in the Stock Market Index.
Liquidity Shocks
Scenario L-1 assumes a 5 percent decline in the liquid liabilities and its impact on liquidity coverage
ratio calculated after excluding Govt. securities under Held to Maturity category from liquid assets.
Scenario L-2 assumes a 10 percent decline in the liquid liabilities and its impact on liquidity coverage
ratio calculated after excluding Govt. securities under Held to Maturity category from liquid assets.
Scenario L-3 assumes a 5 percent decline in the liquid liabilities and its impact on liquidity coverage
ratio calculated after including Govt. securities under Held to Maturity category in liquid assets.
Scenario L-4 assumes a 10 percent decline in the liquid liabilities and its impact on liquidity coverage
ratio calculated after including Govt. securities under Held to Maturity category in liquid assets.
SBP
BOX 6.2
Results of “Stress Tests” of Pakistan's Banking System
Mar-06
Single and multifactor sensitivity tests
Credit Shocks
Scenario C-1
Scenario C-2
Scenario C-3
Scenario C-4
Scenario C-5
Deterioration in the quality of loan
Withdrawal of Benefit of FSV
Combined impact of Scenario C1 & C2
Deterioration in the quality of loan by 5%
Level of NPLs to loans ratio where capital wipes out (i.e.
34.74% in Mar-06 and 35.09% in Jun-06)
Market Shocks; Interest Rate Shocks
Shift in the yield curve
Scenario IR-1
Steepening of the yield curve (large shock)
Scenario IR-2
Shift & flattenining of the yield curve
Scenario IR-3
Market Shocks; Exchange Rate Shocks
Depreciation of Rs/US$ exchnage rate (double of the
Scenario ER-1
historical high)
Scenario ER-2
Appreciation of Rs/US$ exchnage rate (hypothetical)
Depreciation in ER along with deterioration of quality of FX
Scenario ER-3
Loans (50 % Provisioning)
Market Shocks; Equity Price Shocks
Fall in the KSE index (historical high)
Scenario E-1
Scenario E-2
Fall in the KSE index (hypothetical scenario)
Liquidity Shocks
Liquidity Coverage Ratio
5 Percent Fall in the Liquid Liabilities
Scenario L-1
10 Percent Fall in the Liquid Liabilities
Scenario L-2
5 Percent Fall in the Liquid Liabilities
Scenario L-3
10 Percent Fall in the Liquid Liabilities
Scenario L-4
Note: The results have not been adjusted for deferred tax benefits accruing on these losses.
%age Point
Change in
CAR
Jun-06
Revised CARAfter Shock
%age Point
Change in
CAR
Revised CARAfter Shock
-0.52
-0.98
-1.50
-1.97
11.83
11.37
10.85
10.38
-0.49
-0.98
-1.47
-1.96
12.08
11.59
11.10
10.61
-12.35
0.00
-12.57
0.00
-0.94
-0.84
-0.28
11.41
11.51
12.07
-0.88
-0.62
-0.27
11.69
11.95
12.30
1.42
-0.58
13.77
11.77
0.03
-0.01
12.60
12.56
0.00
12.35
-0.21
12.36
0.00
-0.31
12.35
12.04
-0.14
-0.42
12.43
12.15
Actual
32.9
32.9
39.4
39.4
Stressed
29.4
25.5
36.2
32.6
Actual
36
36
40
40
Stressed
32.6
28.9
36.9
33.4
International Experiences
Adopted by Europe,
 America and
 Many Emerging Economies
A survey conducted on some of these countries reveals
that these countries believe stress testing as a tool
 Interest rates are the most common theme among the
sensitivity stress tests reported on the census.
 Nearly all banks responded that stress tests are used as
a tool for risk managers to understand the firm’s risk
profile and communicate that information to senior
management.

International Experiences…





Banks use stress test limits in combination with other limits, on
notional position size, position sensitivity (ie delta), or VaR.
a majority of the reporting banks have acted on the results of
stress tests.
Three-quarters of global dealer banks and just over half of
internationally active banks answered that stress tests have led to
the unwinding or hedging of a position.
All banks reported that stress tests covered the trading book,
while two-thirds reported that stress tests also covered the
banking book.
The design of stress tests draws heavily on historical events, even
for hypothetical scenarios.
Thank You