| Stress testing is a tool that supplements other risk | | | | the robustness of their internal capital assessments |
| management approaches and measures. It plays a | | | | and the capital cushions above the regulatory |
| particularly important role in: | | | | minimum. |
| 1. Providing forward-looking assessments of risk; | | | | Basel II also requires that, at a minimum, banks |
| 2. Overcoming limitations of models and historical | | | | subject their credit portfolios in the banking book to |
| data; | | | | stress tests. Recent analysis has concluded that |
| 3. Supporting internal and external communication; | | | | implementation of this requirement would not have |
| 4. Feeding into capital and liquidity planning | | | | produced large loss numbers in relation to banks' |
| procedures; | | | | capital buffers going into the crisis or their actual loss |
| 5. Informing the setting of a banks' risk tolerance; | | | | experience. |
| and | | | | Further, the general tests banks are required to |
| 6. Facilitating the development of risk mitigation or | | | | conduct as part of Pillar 2 (SRP - supervisory review |
| contingency plans across a range of stressed | | | | process) might have included more severe scenarios |
| conditions | | | | than the ones currently used and produced results |
| Stress testing is especially important after long | | | | more in line with the actual stresses that were |
| periods of benign economic and financial conditions, | | | | observed. |
| when fading memory of negative conditions can lead | | | | By itself, it cannot address all risk management |
| to complacency and the underpricing of risk. It is also | | | | weaknesses, but as part of a comprehensive |
| a key risk management tool during periods of | | | | approach, it has a leading role to play in strengthening |
| expansion, when innovation leads to new products | | | | bank corporate governance and the resilience of |
| that grow rapidly and for which limited or no loss | | | | individual banks and the financial system. |
| data is available. | | | | A stress test is commonly described as the |
| Pillar 1 (minimum capital requirements) of the Basel II | | | | evaluation of the financial position of a bank under a |
| framework requires banks using the Internal Models | | | | severe but plausible scenario to assist in decision |
| Approach to determine market risk capital to have in | | | | making within the bank. The term is also used to |
| place a rigorous programme of testing. | | | | refer not only to the mechanics of applying specific |
| Similarly, banks using the advanced and foundation | | | | individual tests, but also to the wider environment |
| internal ratings-based (IRB) approaches for credit risk | | | | within which the tests are developed, evaluated and |
| are required to conduct credit risk tests to assess | | | | used within the decision-making process. |