The stress testing in India is governed by the reserve bank of India. The norms were updated with the new BASEL report.
What is Stress Testing?
It is the technique used to understand where the bank can survive the worst economic conditions. It is the test of the institute to check whether the institute can survive the worst conditions.
What are the objectives of stress testing?
The objective of stress testing is to keep the institution moving during a disastrous situation. Banks must manage the risk capacity with the risk exposure under economic and regulatory constrain. They must maintain the minimum capital ratio, solvency, earnings, minimum leverage ratio, and liquidity. Stress testing also helps to assess the new capital plans and to calculate the risk exposure.
Why should the bank adopt stress testing?
Stress testing helps banks to maintain risk mitigation and management practice. It creates transparency in a bank with better data collection and publication. The bank institution realizes the potential of stress testing for business intelligence.
They are focusing on how to formulate the capital and perform business strategies, efficiency, and return investment.
In the current scenario, stress testing works as strategic and profitable.
What are the different areas of stress testing?
1. Risk Appetite:-
To find the growth strategies which impact the availability and deployment of capital. The bank must create business plans to deal with capital allocation and risk-adjusted-performance and incentives. It has to do dynamic monitoring.
2. Risk Management:-
This bank has to identify all types of material risks. They must ensure that the risk management policy must link with the capital limit. They must identify the stress scenario that impacts on liquidity and funding requirement.
3. Balance Sheet Management:-
Institute has to manage the balance sheet with composition to improve the risk-weighted assets and build the response to the external factors. It also includes strategic buffer capital. They must identify the enhanced asset-liability management capabilities to the stress scenario.
4. Capital Management:-
It includes capital target completion. It also includes refining the capital distribution plans and identifying the risk indicator and trigger.
What are the core areas of stress testing?
1. Planning for Crisis:-
It includes calculating the scope of the risk concerning the crisis like a recession. Bank has to find out which of its assets are under danger during or after the recession.
2. Identifying the credit and market risk:-
It comes after the planning. The bank must sort out assets as per the market or credit risk.
3. Maintain stress data system:-
The data system will help with different decisions. It includes the various tax management for product and risk mapping for products.
4. Stress calculation:-
The different data models will help to calculate the stress models for various aspects such as secured and non-secured assets and trading instruments.
It includes the calculation of credit loss, capital ratio calculations, net interest, and non-net interest.
What are the approaches for stress testing?
There are a total of two approaches to stress testing.
1. Top-down approach:-
It evaluates the risk impact on the macroeconomic variables of the bank with the balance sheet and income statement. It helps to find where the bank can survive the risk with the current assets. It requires minimum monitoring and intervention. Top to down approach more depends on the complex models. It does not calculate the heterogeneous portfolio. It is easy to implement. It depends on the assumptions of the models and collateral values. It also calculates the heterogeneous risk of portfolio and co-relation among them. Hence the top-down approach gives predictable and stable results. The top-down give the static balance sheet. Top-down is helpful in benchmark peers bottom to top is difficult for benchmark peers. Top-down does not calculate the idiosyncratic risk of the bank.
2. Bottom-up approach:-
It also evaluates the data for the macroeconomic value of risk but with the equity, debits. The overall result is then collected to give a firm view of bank capital. It requires the continuous validation of the model. The Bottom-up gives a varied result. The Bottom-up gives the dynamic balance sheet. The Bottom-up gives the idiosyncratic risk of the bank.
What are the issues while implementing stress testing?
The inputs for data requires most of the resource are reconciliation application, core banking application, core banking application, and trading application. It is hard to sort out the superior data. Data quality matters a lot while developing the stress testing.
Standardization of Industry:-
Calculating the stress test, every bank follows its approaches. There is no India based imperial study on how to face the stress testing process. India bank yet to approach the perfect way.
The stress testing helps to analyze the risk and the regulations. Banks must balance the gap between risk and profit. The stress testing helps to analyze the situation and to make a firm decision.