Stress testing overview

Stress and scenario analysis is an essential tool in the overall risk management framework. It enables banks to evaluate the impact on capital, liquidity funding and franchise viability based on potential adverse macro-economic and firm-specific scenarios. This is now an integral requirement for the Internal Capital Adequacy Assessment Process (ICAAP) and Internal Liquidity Adequacy Assessment Process (ILAAP), and Recovery and Resolution Plans (RRP) exercises.

Simplified view of Katalysys's stress testing approach

We suggest that banks at the very minimum include 3 scenarios (firm-specific, market-wide and combination of firm-specific & market-wide) in their stress test exercise. In addition to the scenario based stress testing, bank's should also  include sensitivity based analysis (e.g. impact analysis of a 200 basis points increase in interest rates). Once the stress scenarios have been decided, our simplified framework for capital and liquidity impact assessment is shown in the diagram below.

The results from the stress tests can be used to evaluate the necessary management action. The learnings from the stress testing exercise are used to refine bank's risk appetite, metrics and measures, and policies and procedures, which ensures the continued resilience of the bank's overall risk management framework and governance.