Banks Act, 1990 (Act No. 94 of 1990)RegulationsRegulations relating to Banks' Financial Instrument TradingChapter 7 : Use of Internal Models28. Stress testing |
| (1) | A bank that uses the internal model approach for the calculation of position-risk requirements shall have in place a rigorous and comprehensive stress testing programme. Stress testing shall identify events or influences that could greatly impact on a bank and is a key component of the bank's assessment of its capital-adequacy position. |
| (2) | A bank's stress scenarios need to cover a range of factors that can create extraordinary losses or gains in trading portfolios, or that can render the control of risk in those portfolios very difficult. These factors include low-probability events in all major types of risk, including the various components of market, credit, and operational risks. Stress scenarios shall shed light on the impact of such events on positions that display both linear and non-linear price characteristics (that is, options and instruments that have options-like characteristics). |
| (3) | A bank's stress tests shall be both of a quantitative and qualitative nature, incorporating both market risk and liquidity aspects of market disturbances. Quantitative criteria shall identify plausible stress scenarios to which a bank could be exposed. Qualitative criteria should emphasise two major goals of stress testing, namely, evaluation of the capacity of the bank's capital to absorb potential losses and identification of steps that the bank can take to reduce its risk and to conserve capital. This assessment is integral to setting and evaluating the bank's management strategy, and the results of stress testing shall be routinely communicated to senior management and to the bank's board of directors. |
| (4) | A bank shall combine the use of stress scenarios with stress tests developed by the bank itself in order to reflect its specific risk characteristics. The Registrar may request a bank to provide information in the three broad areas set out in paragraphs (a) to (c) below: |
| (a) | Supervisory scenarios requiring no simulations by the bank: A bank shall have information on the largest losses experienced during the reporting period available for supervisory review. This loss information could be compared to the level of capital that results from a bank's internal measurement system. The information must provide the Registrar with a picture of how many days of peak-day losses would have been covered by a given value-at-risk estimate; |
| (b) | scenarios requiring a simulation by a bank: A bank shall subject its portfolios to a series of simulated stress scenarios and shall provide the Registrar with the results. These scenarios shall include testing the current portfolio against past periods of significant disturbance, incorporating both the large price movements and the sharp reduction in liquidity associated with such events. A second type of scenario could evaluate the sensitivity of the bank's market-risk exposure to changes in the assumptions about volatilities and correlations. Application of this test would require an evaluation of the historical range of variation for volatilities and correlations and evaluation of the bank's current positions against the extreme values of the historical range. Consideration shall be given to the sharp variation that has at times occurred in a matter of days during periods of significant market disturbance. (The 1987 equity crash, for example, involved correlations within risk factors approaching the extreme values of 1 or -1 for several days at the height of the disturbance); and |
| (c) | scenarios developed by a bank itself in order to capture the specific characteristics of its portfolio: In addition to the scenarios prescribed by the Registrar under (a) and (b) above, a bank shall also develop its own stress tests, which it identifies as most adverse, based on the characteristics of its portfolio (for example, problems in a key region of the world combined with a sharp move in oil prices). A bank shall provide the Registrar with a description, in writing, of the methodology used in order to identify and carry out the scenarios, as well as with a description of the results derived from these scenarios. |
| (5) | Stress results shall be reviewed periodically by senior management and shall be reflected in the policies and limits set by management and the board of directors. When the testing reveals particular vulnerability to a given set of circumstances, the Registrar may require the bank to take prompt steps in order to manage those risks appropriately (for example, by hedging against that outcome or reducing the size of its exposures). |