INTEGRATED TREASURY WITH EMPASIS ON RISK

MANAGEMENT - STRESS TESTING

A PROJECT REPORT

FOR UNION BANK OF INDIA

SUBMITTED BY

RITESH

PGDM 2009 – 2011

AUGUST 2010

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 EXECUTIVE SUMMARY

The project I undertook was to study the importance of treasury risk management
and stress testing under the same. Main objective behind this is to know about the importance of
stress testing in India and to understand the working of the same. In India, risk management
techniques especially are developing at a very slow pace as compared to international banking
industry.

The project contains study and understanding of the treasury departments in banks,
what are the major components of treasury department, developing role and importance of
stress testing in the Indian banking industry

I got a wide exposure of treasury department while working on the project. I also
understood working of this department and how it is different from other department, products
of banks.

PROJECT TITLE

Integrated Treasury with emphasis on risk management – Stress Testing

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TABLE OF CONTENTS

SR.NO PARTICULARS PAGE NOS.

1
1 Executive Summary

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3 Objective of treasury operations in Banks

4 Risk Management 13

6 Risk management of Treasury operations in banks 17

7 Stress Testing 21

8 Stress testing guidelines and mechanism 24

9 Stress Tests: Testing Financial Health 29

10 Case of Stress Testing in Nigerian Banks 34

11 Conclusions 36

12 Bibliography 37

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4
Objective of treasury operations in Banks

1. Reserve Management & Investment: It involves

(i) Meeting CRR / SLR obligations
(ii) Having an appropriate mix of investment portfolio to optimize yield and duration.

Duration is the weighted average ‘life’ of a debt instrument over which investment in
that instrument is recouped. Duration Analysis is used as a tool to monitor the price
sensitivity of an investment instrument to interest rate changes.

2. Liquidity & Funds Management: It involves

(i) Analysis of major cash flows arising out of asset-liability transactions
(ii) Providing a balanced and well-diversified liability base to fund the various assets in
the balance sheet of the bank
(iii) Providing policy inputs to strategic planning group of the bank on funding mix
(currency, tenor & cost) and yield expected in credit and investment.

3. Asset Liability Management & Term Money: ALM calls for determining the optimal size
and growth rate of the balance sheet and also prices the Assets and Liabilities in
accordance with prescribed guidelines. Successive reduction in CRR rates and ALM
practices by banks increase the demand for funds for tenor of above 15 days (Term
Money) to match duration of their assets.

4. Risk Management - Integrated treasury manages all market risks associated with a
bank’s liabilities and assets. The market risk of liabilities pertains to floating interest
rate risks and asset & liability mismatches. The market risk for assets can arise from
(i) Unfavorable change in interest rates
(ii) Increasing levels of disintermediation
(iii) Securitization of assets
(iv) Emergence of credit derivatives etc.

While the credit risk assessment continues to rest with Credit Department, the Treasury
would monitor the cash inflow impact from changes in asset prices due to interest rate
changes by adhering to prudential exposure limits.

5. Transfer Pricing: Treasury is to ensure that the funds of the bank are deployed
optimally, without sacrificing yield or liquidity. An integrated Treasury unit has an idea
of the bank’s overall funding needs as well as direct access to various markets (like
money market, capital market, forex market, credit market). Hence, ideally treasury
should provide benchmark rates, after assuming market risk, to various business groups
and product categories about the correct business strategy to adopt. f. Derivative

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Products: Treasury can develop Interest Rate Swap (IRS) and other Rupee based / cross-
currency derivative products for hedging Bank’s own exposures and also sell such
products to customers/other banks. g. Arbitrage: Treasury units of banks undertake this
by simultaneous buying and selling of the same type of assets in two different markets
to make risk-less profits.

6. Capital Adequacy: This function focuses on quality of assets, with Return on Assets
(RoA) being a key criterion for measuring the efficiency of deployed funds.

An integrated treasury is a major profit centre. It has its own P & L measurement. It
undertakes exposures through proprietary trading (deals done to make profits out of
movements in market interest /exchange rates) that may not be required for general
banking.

Risk Management

Risk is inherent part of Bank’s business. Effective Risk Management is critical to any
Bank for achieving financial soundness. In view of this, aligning Risk Management to
Bank’s organizational structure and business strategy has become integral in banking
business. Over a period of year, Union Bank of India (UBI) has taken various initiatives
for strengthening risk management practices. Bank has an integrated approach for
management of risk and in tune with this, formulated policy documents taking into
account the business requirements / best international practices or as per the guidelines
of the national supervisor. These policies address the different risk classes viz., Credit
Risk, Market Risk and Operational Risk.

The issues related to Credit Risk are addressed in the Policies stated below;

Loan Policy.
Credit Monitoring Policy.
Real Estate Policy.
Credit Risk Management Policy.
Collateral Risk Management Policy.
Recovery Policy.
Treasury Policy.

The Policies and procedures for Market Risks are articulated in the ALM Policy and
Treasury Policy.

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The Operational Risk Management involves framework for management of operational
risks faced by the Bank. The issues related to this risk is addressed by;

Operational Risk Management Policy.

Business Continuity Policy.
Outsourcing Policy.
Disclosure Policy.

Besides, the above Board mandated Policies, Bank has detailed ‘Internal Control
Principles’ communicated to the business lines for ensuring adherence to various norms
like Anti-Money Laundering, Information Security, Customer complaints, Reconciliation
of accounts, Book-keeping etc.

Risk management of Treasury operations in banks

BANK managements are highly sensitive to Treasury risks, as they arise out of the high
leverage of the Treasury business. The risk of losing capital is much higher than, say, in
the credit business. The second reason for managements' concern is the large size of the
transaction done, at the sole discretion of the treasurers. The conventional control and
supervisory measures, mostly in the nature of preventive steps, can be divided into
three parts:

 Organizational controls: This refers to the checks and balances within the system.
Treasury is divided in two parts — the front and back office. The front office generates
deals and the back office settles trades only after verifying compliance with the internal
controls.

 Exposure limits: These caps are put in place to protect the bank from credit risk,
which, in Treasury, may be of defaulters and counter party.

 Internal controls: The most important of the internal controls are position and stop-
loss limits. The trading limits are of three kinds:

a) On deal size,

b) On open positions, and

c) Stop-loss.

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Treasury faces Market Risk (which broadly covers that of liquidity, interest rate,
exchange rate and equity price); credit risk, and operational risk.

Market risk management

Treasury investments are categorized into government securities, other approved

securities, shares, debentures and bonds, commercial papers, and mutual funds. In line
with international best practices, the investments are classified into three categories —
Held to Maturity, Available for Sale and Held for Trading. The investments made to earn
profits from the short-term price movements are classified under the Held-for-Trading
Category, whereas the securities contracted basically on account of relationship or for
steady income and statutory obligations are classified under Held-To-Maturity (HTM)
category. The securities, which do not fall under these categories, are classified as
Available-for-Sale. The securities Held-for-Trading (HFT) and Available-for-Sale (AFS) are
to be marked-to-market periodically. As per the RBI, Trading Book includes HFT and AFS
and Banking Book refers to HTM.

Held-to-Maturity

The risks inherent in the HTM portfolio:

Price risk if the acquisition cost is above par. The premium over the par value will be
amortized annually till maturity.

Re-investment risk due to reinvestment of high yielding security inflow at lower yields.

Held-for-Trading

Classification as HFT should be an explicit management decision considering the

intention, the trading strategies, the risk management capabilities, the capital position
and the manpower skills. Securities classified HFT are to be sold within 90 days
(defeasance period). Shifting of securities from HFT to AFS is permitted only under
exceptional circumstances such as tight liquidity conditions, extreme volatility or
exceptional market conditions. The shifting requires the approval of Board of
Directors/ALCO/Investment Committee.

Available-for-Sale

These assets in the Trading Book are held for generating profit on differential
interests/yields. Ideally, the securities held in the Trading Book are marked-to-market
on a daily basis.

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Investment Fluctuation Reserve

This is maintained to guard against any possible reversal of interest rate environment on
unexpected developments. It is prudent to transfer maximum amount of gains realized
on sale of securities to the IFR. Banks are free to build IFR up to 10 per cent of the
investment portfolio under HFT and AFS with the approval of the Board of Directors

Interest rate risk

Management of interest rate risk aims at capturing the risks arising from the maturity
and re-pricing mismatches of various rate-sensitive assets and liabilities. The interest
rate risk is measured from earnings and economic value perspective.

Earnings perspective involves analyzing the impact of changes in the interest rate on
accrual or reported earnings in the near term, measured by changes in the Net Interest
Income. Economic Value perspective involves analyzing the changes of impact of interest
on the expected cash flows on assets minus the expected cash flows on liabilities plus
the net cash flows on off-balance-sheet items. The level of interest rate changes is an
important factor to choose fixed/floating interest rate assets/liabilities, their maturities
and hedging decisions.

Interest rate risks in the Trading Book arise due to:

i) The volatility in the interest rate; this will have an impact on exercising the
embedded options, ii) Different benchmark interest rates not moving up or down by
same basis points, iii) Different currency interest rates not moving up or down by the
same basis points, iv) The impact on the interest costs/yield of debt instruments not be
equal due to non-parallel shift in the yield curve, v) A the highly inflationary economy;
managing interest rates in such a situation is a big challenge, vi) Competition and
business compulsions; the bank may change the interest rates opposite to the general
market movement of interest rate.

Middle Office: One of the important organisation structures in Risk Management, it is

responsible for the critical functions of independent market risk monitoring,
measurement, analysis and reporting for the bank's ALCO. Middle Office should
independently report to ALCO.

Liquidity risk

The liquidity risk in Treasury manifests in different dimensions:

i) Funding Risk: It arises due to replacement of liabilities withdrawn, ii) Time Risk: It
arises due to the need to compensate for non-receipt of expected inflows of funds, that
is, performing assets turning into non-performing assets; and iii) Call Risk: It arises on
the crystallisation of contingent liabilities and the inability to leverage profitable
business opportunities when desirable.

Exchange risk

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Available accounting information do not provide a reliable base to calculate exposure
and the actual risk a bank faces, which depends on its future cash flows and their
associated risk profiles. There is the distinction between the currency in which cash
flows are denominated and the that which determines the size of the cash flows. For
example, a borrower selling jewellery in Europe may keep his records in rupees, invoice
in euros, and collect euro cash flow, only to find that its revenue stream behaves as if it
were in US dollars. Trading in the forex market is fraught with `market risks'. With rupee
moving towards full convertibility and the reduced `direct' intervention by the central
bank, USD/INR has increased volatility in the forex market. Rupee, which was firming up
from the 49/dollar levels (during September 2000) in the past, has started rebounding
from 43 (July 2005) levels to 46.40 levels (as of December 5) on the back of recovery of
the dollar globally. Added to this, the dollar gained strength on account of 12 successive
increases in rates, by 25 bps each from June 2003 (an increase from 1 pct to 4 pct). The
forward market has also been moving in tandem with Spot INR, easing up a bit for every
gain of the rupee against the USD. Six months annualized premier, which was at 2.91 pct
in November 2004 was down to 0.27 pct in September 2005. However when the rupee
started to move south, Forwards too tracked it for the six months forwards to go.

Measurement of interest rate risk

The methods to measure of Interest Rate Risk in trading book are:

i) Duration Gap analysis: Duration is a value and time weighted measure of maturity that
considers the timing of all cash inflows from assets and all cash outflows associated with
liabilities. It measures the average maturity of a promised stream of future cash
payments. In effect, duration measures the average time needed to recover the funds
committed to an investment.

ii) Convexity: Convexity is the rate of change of duration. Compared to duration, it is a

better measure of price sensitivity for larger change in interest rates.

iii) Simulations: Simulations are computer-generated scenarios about the future that
permit banks to analyze interest rate risk and business strategies in a dynamic
framework. Given such information, banks may evaluate the desirability of various
courses of action. The scenarios are based on assumptions, such as changes in interest
rates, shape of yield curve, pricing strategies, growth volume and mix of assets and
liabilities and hedging strategies.

iv) VaR based methodology: VaR is an estimate of potential loss in a position or

asset/liability or portfolio of assets/liabilities over a given holding period at a given
level of certainty.

The Bank of International Settlements has accepted VaR as a measurement of market

risks and provision for capital adequacy for market risks.

VaR is used as a MIS tool in the trading portfolio to "slice and dice" risk by
levels/products/geographic/level of organization etc.

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Stress Testing

Stress testing is the topic of the day. Recently leading US banks underwent stress testing
under the Supervisory Capital Assessment Program conducted by the Board of Governors
of Federal Reserve System in the United States of America.

A banking organization holds capital to guard against uncertainty. Capital reassures an

institution’s depositors, creditors and counterparties‐‐and the institution itself‐‐that an
event such as an unexpected surge in losses or an unanticipated deterioration in
earnings will not impair its ability to engage in lending to creditworthy borrowers and
protect the savings of its depositors.

The assessment and monitoring of strengths and vulnerabilities of financial systems is

called macro prudential analysis. Macro prudential analysis uses quantitative information
on the financial system as well as qualitative information on the institutional and
regulatory frame work.

It encompasses surveillance of financial market conditions and analysis of macro

financial linkages. It is in turn part of a broader framework of macroeconomic
vulnerability assessment, which includes the balance sheet approach, debt sustainability
analysis and monitoring of macroeconomic conditions.

One of the key techniques for quantifying financial sector vulnerabilities is stress
testing. The term stress testing refers to a range of statistical techniques used to help
assess the vulnerability of a financial system to exceptional but plausible events.

System-wide stress tests (or macro financial stress tests) measure the impact of shocks
on financial system stability.

Compared to stress tests for individual financial institutions, the system-wide stress
tests have—as the name suggests—wider coverage (i.e. the financial system or a
systemically important part of it), are used for a different purpose (financial sector
surveillance rather than risk management), focus more on channels of contagion (i.e.
how a risk to one institution can become a systemic risk), and often have to use more
streamlined techniques (because of the ensuing complexity of the calculations).

Also, system-wide stress testing is a much newer concept, and the literature on the
topic is consequently much shorter than that on stress testing for individual institutions.

Stress tests can be classified, by methodology, into three main types: (i) sensitivity
analysis, which seeks to identify how portfolios respond to changes in relevant economic
variables (such as interest rates and exchange rates); (ii) scenario analysis, which seeks
to assess the resilience of financial institutions and the financial system to an

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exceptional but plausible scenario; and (iii) contagion analysis, which seeks to take
account of the transmission of shocks from individual exposures to the financial system
as a whole.

The importance of stress testing for macro prudential analysis derives from integrating a
forward looking macroeconomic perspective, a focus on the financial system as a whole,
and a uniform approach to the assessment of risk exposures across banks.

Unlike the stress tests conducted at large banks, which are designed to measure
portfolio- and bank-specific risk exposures, system wide stress tests apply a common set
of scenarios based on an assessment of macroeconomic and market risks. This uniform
approach allows for the aggregation of results, helping to identify key vulnerabilities at
the level of the overall system, and providing comparable information on risk profiles
across banks.

Stress testing is primarily about identifying latent exposures. There is little need to
perform complicated stress test calculations if the exposures are obvious, or obviously
lacking. Stress tests are needed to identify exposures that are less obvious, perhaps
hidden across a wide variety of instruments, credits, and derivatives positions.

System-wide stress testing can be viewed as a multi-step process of examining the key
vulnerabilities in the system. This involves: identifying the major risks and exposures in
the system and formulating questions about those risks and exposures; defining the
coverage and identifying the data required and available; calibrating the scenarios or
shocks to be applied to the data; selecting and implementing the methodology; and
interpreting the results.

To be relevant, stress tests must probe the consequences of potential shocks that are
related to the macroeconomic risks that exist in the actual situation of the country. The
process of designing system-wide stress tests therefore typically starts with a discussion
of the potential risks faced by the economy. The discussion then suggests that certain
types of shocks (e.g. a potential increase in interest rates or a depreciation of the
currency) are more likely in the given economy than other types of shocks.

The fact that there are macroeconomic risks that could result in shocks to the financial
system does not necessarily mean that the impact of the shocks would be large. The
impact can still be small if the exposures in the system are small. It is the purpose of the
stress tests to assess how the risks combine with the exposures. The design of stress
tests is often an iterative process, since some originally identified risks may lead to
relatively small impacts, while some risks originally assessed as small may lead to large
impacts if there are substantial exposures.

Even if the exposures are large and stress tests identify a potentially large impact on the
financial system, it is the purpose of the other parts of the macro prudential analysis to
assess the likelihood that these impacts can be mitigated by prompt action by
supervisors and banks.

Banks in India are beginning to use statistical models to measure and manage risks.
Stress tests are, therefore, relevant for these banks. Notwithstanding the use of
statistical models, stress tests are a relevant and integral part of banks' risk

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management frameworks. Further, the supervisory review process under Pillar 2 of Basel
II framework is intended not only to ensure that banks have adequate capital to support
all the risks in their business, but also to encourage banks to develop and use better risk
management techniques in monitoring and managing their risks.

In the above background, the need for banks in India to adopt ‘stress tests’ as a risk
management tool has been emphasised in the Annual Policy Statement for 2006-07.
Accordingly, the draft guidelines on stress testing were prepared and issued for
feedback from banks. On the basis of the feedback received, the draft guidelines have
been suitably revised. Guidelines on stress testing, as relevant for the Basel II
framework, will be issued separately.

Reserve Bank of India in notification dated 26th June 2007 has asked banks to put in
place a Board approved ‘Stress Testing framework’ to suit their individual requirements
which would integrate into their risk management systems. Banks need to put in place
appropriate stress test policies and the relevant stress test framework for the various
risk factors by September 30, 2007.

As banks may need to undertake the stress tests on a trial basis and use the results of
these trial tests as a feedback to further refine the framework, RBI has decided that
banks be allowed some time to refine the stress testing frameworks. Banks are required
by RBI to ensure that their formal stress testing frameworks, which are in accordance
with the guidelines, are operational from March 31, 2008.

Stress testing guidelines and mechanism

1. Introduction

1.1. Banks are undertaking increasingly complex financial operations (both in credit,
trading and other related services), which are exposing them to several risks. Bank
credit has always been a dynamic instrument of growth in India even post economic
liberalization. Establishing and strengthening enterprise-wide Risk Management
System and Capital allocation within a bank is getting more important as the
regulatory requirements are moving towards economic-based measures of risk.
Banks are urged to build sound internal measures of credit, operational and market
risks for all their activities.

1.2. Internationally, banks are increasingly relying on statistical models to measure and
manage the financial risks to which they are exposed. These models are gaining
credibility because they provide a framework for identifying, measuring,
communicating and managing risks. Stress Tests are resorted to, as the existing
models cannot incorporate all possible risk outcomes arising out of sudden and
dramatic changes.

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1.3. Globally, stress testing has become an integral part of banks’ risk management
systems and is used to evaluate the potential vulnerability to some unlikely but
plausible events or movements in financial variables. Stress testing typically refers
to shifting the values of individual parameters that affect the financial position of
a firm and determining the effect on the firm’s business. It is an estimation of
potential economic losses in the portfolio by subjecting the same to an abnormal
market scenario. Ideally, stress testing can and should be applied to the entire
range of risks that an organization runs. However, stress testing of credit portfolio
and for liquidity funding is becoming more developed, but stress testing for
operational risk and aggregation across risk elements is at an early stage of
development.

1.4. Banks in India are beginning to use statistical models to measure and manage risks.
Stress tests are, therefore, relevant for these banks. Notwithstanding the use of
statistical models, stress tests are a relevant and integral part of banks' risk
management frameworks. Further, the supervisory review process under Pillar 2 of
Basel II framework is intended not only to ensure that banks have adequate capital
to support all the risks in their business, but also to encourage banks to develop
and use better risk management techniques in monitoring and managing their risks.

1.5. With a view to improve risk management practices in banks, Reserve Bank of India
(RBI) has issued guidance notes on Asset Liability Management, Management of
Credit Risk, Market Risk and Operational Risk since 1999. Further, the
announcement of New Capital Adequacy Framework (NCAF) in India has brought
the risk management capabilities of banks into greater focus. In its annual policy
statement for 2006-07, RBI has emphasized the need for Banks in India to adopt
‘Stress Tests’ as a risk management tool. In general, RBI’s stance has always been
one of gradual convergence with international best standards with suitably country
specific adaptations.

1.6. In June 2007, RBI has issued guidelines on Stress Testing and advised banks to put
in place board approved ‘Stress Testing Policy’ and relevant stress test framework
for various risk factors. Till such time, banks are to undertake the stress tests on
trial basis and use the results of these tests to further refine the framework.
However, banks should ensure that their formal stress testing frameworks are
operational from March 31, 2008.

1.7. This Stress Testing Policy should cover the aspects like, a) frequency and procedure
for identifying the principal risk factors which affect the bank’s portfolio and
should be stressed; b) methodology for constructing appropriate and plausible
single factor and multi factor stress tests; c) procedure for setting the stress
tolerance limits; d) process for monitoring the stress loss limits; e) remedial
actions required to be taken at the relevant stages; f) authorities designated to
activate the remedial actions; g) need for identification of the responsibilities
assigned to various levels/functional units; h) need for specification of reporting
lines.

1.8. Types of Stress testing: There are broadly two categories of stress tests used in
Banks viz. Sensitivity tests and Scenario tests. These may be used either
independently or in conjunction with each other.

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 1.8.1. Sensitivity Tests are normally used to assess the impact of change in one
variable (for example, a high magnitude parallel shift in the yield curve, a
significant movement in the Foreign Exchange rates, a large movement in the
equity index etc) on the bank’s financial position.

1.8.2. Scenario Tests include simultaneous moves in a number of variables based on

a single event experienced in the past (historical scenario) or a plausible
market event, which has not yet occurred, and the assessment of their
probable impact on the Bank’s financial position. Scenario analysis measures
the combined effect of adverse movements in more than one risk factor. E.g.
domestic economic downturn, tightening of market liquidity, increase in credit
risk downgrades, repricing, basis, yield curve risk or option risk.

2. Objectives:

This Stress Testing Policy aims to:

2.1. Supplement bank’s risk management system and help in making these
systems more robust.

2.2. Enable the bank to be better equipped to meet the stress situations as and
when they arise and overcome them as well.

2.3. Assess the potential impact of stress situations on the bank’s earnings and
Capital position and also to develop appropriate strategies for mitigating
and managing the impact of those situations.

2.4. Perform the dual role of being a diagnostic tool for improving the bank’s
understanding of it’s risk profile and for introducing forward looking
element in the Capital Assessment process.

2.5. To hold capital buffer that would be aligned to the exceptional but
plausible stress situations.

2.6. Serve as an important component of bank’s Internal Capital Adequacy

Assessment process (ICAAP) under Basel II.

2.7. Build additional reserves as cushion to meet the depreciation losses due to
stress events and add strength to Balance Sheet.

3. Frequency & Procedure for identifying the principal risk factors to be

stressed:

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 3.1. The competent authority for identifying the principal risk factors to be
stressed would be Credit Risk Management Committee (CRMC) for Credit
Risk, Asset Liability Committee (ALCO) for Market Risk and Operational Risk
Management Committee (ORMC) for Operational Risk. The frequency for
identifying the principal risk factors would be annual. The CRMC, ORMC and
ALCO shall be responsible for:

3.1.1. Identifying the principal risk factors which affect the bank’s
portfolio and should be stressed;

3.1.2. Approving the methodology for constructing appropriate and

plausible single factor and multi factor stress tests.

3.1.3. Approving the underlying assumptions and the level of stress to be

applied;

3.1.4. Setting the stress tolerance limits;

3.1.5. Reviewing the stress test results and monitoring the stress loss
limits;

3.1.6. Put in place appropriate contingency plans for meeting the

situations that may arise under adverse circumstances and to
activate necessary remedial measures to counter any such
situation/s;

3.1.7. Allocating capital for various risks;

3.1.8. Periodically communicating the stress test results and the actions
taken, if any to the Board;

3.1.9. Reviewing the need to modify the stress testing framework with
reference to certain elements like the risk factors, stress scenarios,
levels of stress to be applied, the underlying assumptions, stress
tolerance levels, remedial actions etc,; and

3.1.10. Designing an appropriate MIS to support the stress tests to be

conducted; and ensuring an appropriate and effective internal
control mechanism to validate the stress tests and their findings.

3.2. The Supervisory Committee of Directors on Risk Management and ALM /

Board of Directors shall regularly review the results of scenario analysis and
stress tests, including the major assumptions that underpin them.

4. Methodology for conducting appropriate stress tests:

4.1. Bank will conduct stress tests / scenario analysis at quarterly intervals to
include the following risks:

Liquidity Risk:

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 4.1.1. Deposit run-offs in a bank specific event
4.1.2. Deposit run-offs in a market specific event

Interest Rate Risk:

.1.3. Unfavourable differential changes in key interest rates

4.1.4 Impact on the trading book due to event based stress scenarios
such as policy changes and subsequent impact on bond / equity
market.

Credit Risk:

4.1.4. Economic downturn – Downgrade for different rating grades

4.1.5. Changes in provisioning requirement for various asset categories

Foreign Exchange Risk:

4.1.6. Adverse movement in exchange rates

4.2 Since Operational Risk is still at a nascent stage of development stress tests
will be conducted once data on operational risk areas is available.

4.3 Stress scenarios shall be designed on the basis of either historical events or
hypothetical events. Bank shall carry stress test based on the relevant
parameters at three levels of increasing the adversity – Minor, Medium and
Major, with reference to Normal situation and estimate the financial
resources needed by it under each of the circumstances to:
4.3.1 meet the risk as it arises and for mitigating the impact of
manifestation of that risk,
4.3.2 meet the liabilities as they fall due, and
4.3.3 meet the minimum CRAR requirements.

5. Frequency of Stress Testing:

5.1 Bank shall conduct stress tests on the various risks at quarterly intervals.
However, Bank shall apply stress at varying frequencies as warranted by
the respective business requirements, relevance and costs. For e.g. Daily
or weekly for trading book items or for various market risks and quarterly
for less volatile items like credit risk in loans or HTM securities, interest
rate risk in the banking book etc.
5.2 Bank shall conduct stress test on ad-hoc basis as may be warranted when
there are any special circumstances – for example, a rapidly deteriorating
political / economic conditions in a country may warrant a quick
assessment of the likely impact on the bank on account of its exposures to
that country.

6. Procedure for setting and monitoring the stress tolerance limits:

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 6.1 Stress tolerance limits may be fixed after comparing the trend of stress
results for at least 8 quarters.
6.2 Once the stress tolerance limits are fixed, the stress test results should be
compared with the limits and immediate corrective remedial action should
be initiated in case of breach in limits.
6.3 The respective functional departments viz. Resource Mobilisation,
Treasury, Corporate Credit and SME etc should initiate necessary corrective
action.

7. Reporting Framework:

7.1. Stress Testing on various risks shall be done at periodic intervals by the
Risk Management Department and reported to CRMC/ ORMC/ ALCO for
Credit, Operational and Market Risk respectively. Notes placed to CRMC,
ORMC and ALCO indicating the assumptions, results and outcome of the
stress testing exercise shall be placed before the Supervisory Committee of
Directors on Risk Management / ALM for information and directions.

8. Documenting Stress Testing

8.1. Bank shall document the stress tests undertaken, the underlying
assumptions, the results and the outcomes. The Bank shall preserve the
documentation at least for a period of 5 years. The bank shall make
available for verification by the Supervisor/ Auditors on the various stress
tests carried out.

9. Policy Review

9.1. This Stress testing Policy shall be reviewed on annual basis taking into
account the assumptions underlying the stress test conducted earlier, for
further refinement. These periodic reviews shall be necessary to ensure the
integrity, accuracy, and reasonableness of the stress-testing framework. The
reviews will cover:
9.1.1. Adequacy of documentation
9.1.2. Integration of the stress testing framework in the day-to-day risk
management processes
9.1.3. Scope of coverage of the framework and the levels of stress applied
9.1.4. Integrity of MIS and data feeding into the stress tests and
9.1.5. Adequacy of remedial action and efficiency of the systems for their
activation.
9.2. In emergency situations, Chairman and Managing Director or in his
absence, Executive Director shall be the competent authority to revise and
/ or amend this policy based on recommendations of CRMC/ORMC/ALCO
and subject to ratification by the Supervisory Committee of Directors on
Risk Management and ALM in its next meeting thereafter.

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Stress Tests: Testing Financial Health

The current financial crisis has underscored the importance of detailed knowledge about
the vulnerabilities of the financial sector, especially the banks. One of the tools that
helps to gauge how well a bank's balance sheet and financials can weather a variety of
shocks is stress testing. Although stress tests were originally developed for use with
trading portfolios, they have now become a widely used risk management tool. These
tests alert the bank management to adverse and unexpected outcomes related to a
variety of risks and provide an indication of how much capital might be needed to absorb
losses, should large shocks occur.

The stress test is generally used to monitor the functioning of the heart and vascular
system of a human being when he exercises. This test helps answer two general
questions: 1) Does the person have Coronary Artery Disease (CAD), which only becomes
apparent when the heart is stressed out by exercise? 2) If there is an underlying heart
disease, how severe is it likely to be? To test the condition of the heart, the patient
either walks on a treadmill or is given an intravenous medication that simulates the
exercise while being connected to an Electrocardiogram (ECG) machine, usually with the
standard 10 connections used to record a 12-lead ECG. The level of exercise is increased
in three-minute stages of progressively increased grade (% incline) and speed (mph,
km/h, etc.). The patient's symptoms and blood pressure responses are repeatedly
checked.

Based on a similar concept, a stress test of banks' and financial institutions' balance
sheet is an evaluation of a bank's financial position under a severe but possible scenario
to assist in decision making within the bank. Further, stress testing alerts bank
management to adverse unexpected outcomes related to a variety of risks and provides
an indication of how much capital might be needed to absorb losses, should large shocks
occur. By itself, stress testing cannot address all risk management weaknesses, but as
part of a comprehensive approach, it has a major role to play in strengthening bank
corporate governance and the resilience of individual banks and the financial system.

`Stress testing' has been adopted as a generic term describing various techniques used
by financial firms to gauge their potential vulnerability to exceptional, but plausible,
events. The most common of these techniques involve:

 To determine the impact of a particular strategy on the portfolio of a firm or

business unit in a particular market risk factor (a simple sensitivity test) or of a
simultaneous strategy in a number of risk factors, reflecting an event which the
firm's risk managers believe may occur in the foreseeable future (scenario
analysis). The scenarios are developed, either by drawing on significant market
events experienced in the past (historical scenarios), or by visualizing the

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 consequences of a plausible market event which has not yet happened
(hypothetical scenarios).

 Other techniques used by some firms to capture their exposure to extreme

market events include a maximum loss approach, in which risk managers estimate
the combination of market moves that would be most damaging to a portfolio,
and extreme value theory, which is the statistical theory concerned with the
behavior of the `tails' of a distribution of market returns.

 Stress testing process includes setting stress testing objectives, defining

scenarios, discussing the results of stress tests, assessing potential actions and
decision making.

Stress tests enable managers to track a firm's exposure to price changes during events
that are considered reasonable. This, in turn, allows senior management and business
unit heads to determine whether the firm's exposures correspond to its risk appetite.
Because of their intuitive appeal, stress tests are thought to facilitate the dialogue
between risk managers, senior managers and business unit heads about the risks taken
by the firms and methods for monitoring and managing those risks. From the stress tests
process, the decisions regarding the limits to be set on proprietary position taking,
capital charges on traders and trading units and the appropriateness of the risk
managers' modeling assumptions can be taken. It should be emphasized that stress tests
are typically only one element of the process through which a financial firm develops its
quantitative and qualitative risk management policies.

The depth and duration of the current financial crisis has led many banks and
supervisory authorities to question whether stress testing practices were sufficient prior
to the crisis and whether they were adequate to cope with rapidly changing
circumstances. Involvement of the boards and senior management is critical in ensuring
the appropriate use of stress testing in banks' risk governance and capital planning.

In the present scenario, where many of the big banks in the US have been highly exposed
to the financial crisis, senior managements of these banks, as a whole, have taken an
active interest in the development and operation of stress testing, with the results of
stress tests serving as inputs for strategic decision- making, which has benefitted the
banks. (Refer Table 1)

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Stress testing practices at most banks, however, did not foster internal debate nor
challenge prior assumptions, such as the cost, risk and speed with which new capital
could be raised or that positions could be hedged or sold.

Stress tests cover a range of methodologies. Complexity can vary, ranging from simple
sensitivity tests to complex stress tests, which aim to assess the impact of a severe
macroeconomic stress event on measures like earnings and economic capital. Stress
tests may be performed at varying degrees of aggregation, from the level of an
individual instrument up to the institutional level. Stress tests are performed for
different risk types including market, credit, operational and liquidity risk.
Notwithstanding this wide range of methodologies, the crisis has highlighted several
methodological weaknesses.

Methodology for Stress Testing

Earlier, stress testing at some banks was performed mainly as an isolated exercise by the
risk function with little interaction with business areas. The crisis has revealed serious

21
flaws with relying solely on such an approach. In a recent paper, the Bank for
International Settlements (BIS), has listed the key principles that banks must follow to
design more foolproof stress tests. This would involve four possibilities:

1. Simulating shocks which we suspect are more likely to occur than what historical
observations suggest.

2. Simulating shocks that have never occurred.

3. Simulating shocks that reflect the possibility that statistical patterns could break
down in some circumstances, and

4. Simulating shocks that reflect some kind of structural breakdown that could occur in
the future.

To begin with, stress testing should form an integral part of the overall governance and
risk management culture of the bank. Stress testing should be actionable, with the
results from stress testing impacting decision making at the appropriate management
level, including strategic business decisions of the board and senior management. Board
and senior management involvement in the stress testing program is essential for its
effective operation. Senior management should be able to identify and clearly articulate
the bank's risk appetite and understand the impact of stress events on the risk profile of
the bank. Senior management must participate in the review and identification of
potential stress scenarios, as well as contribute to risk mitigation strategies. A bank
should operate a stress testing program that:

 Promotes risk identification and control.

 Provides a complementary risk perspective to other risk management tools.

 Improves capital and liquidity management, and

 Enhances internal and external communication.

Stress tests must play an important role in the communication of information about risk
within the bank. In contrast to purely statistical models, plausible forward-looking
scenarios are more easily grasped and assist in analyzing the vulnerabilities and
evaluating the feasibility and effectiveness of potential counteractions.

Stress testing programs must take account of views from across the organization and
should cover a range of perspectives and techniques. Banks must use multiple
perspectives and a range of techniques in order to achieve comprehensive coverage in
their stress testing programs. These include quantitative and qualitative techniques to
support and complement the use of models and to extend stress testing to areas, where
effective risk management requires greater use of judgment.

Banks must document the assumptions and fundamental elements for each stress testing
exercise. These include: the reasoning and judgments underlying the chosen scenarios
and the sensitivity of stress testing results to the range and severity of the scenarios. An
evaluation of such fundamental assumptions must be performed regularly or in the light
of changing external conditions and their outcome documented.

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Most importantly, banks must regularly maintain and update their stress testing
framework. The effectiveness of the stress testing program, as well as the robustness of
major individual components, should be assessed regularly and independently. In the
final analysis, the effectiveness and robustness of stress tests should be assessed
qualitatively, as well as quantitatively, as models can never quite substitute for human
judgment.

Approach towards Stress Testing Exercises

Before designing any stress test approach, the first thing we want to know is the goal of
the test. In other words, what questions should the test answer? Some questions might
include the following:

 What would be the loss if the oil price would shoot up to $100 per barrel?

 What would happen if inflation shoots up by 300 bps?

 What would happen if the deposit rate raise by 300 bps?

 What would happen to our risk level if we went into a deep recession?

 Would the recession affect us immediately, or would there be a delay?

 How do differences in local economies affect our risk?

 What would happen to our risk level if interest rates went up significantly?

 What impact do new accounts have on our portfolio risk level?

 If we were to enter a major recession, could we mitigate its impact by focusing

on specific geographies? Would it be better to loosen lending policies in some
areas while tightening them in others?

 What would be the effect of a significant increase in area property values?

 What would happen in the event of a significant shift in the industry composition
of our portfolio?

 Is our small business portfolio more risk sensitive to changes in the economy than
our middle-market accounts?

 How does the economy affect our large customers? Which industries are more
sensitive?

After identifying the relevant shocks (as mentioned above, e.g., demand shock, oil price
increase, etc.), these have to be translated into consistent macro scenarios with the
help of a macro engine. This macro engine could be the macroeconometric model, a VAR
model, or simple historical correlations could be imposed. In the next step, various

23
credit risk models are used to calculate the impact of the macro scenarios on the
financial sector. In the last step, loss measures are identified and estimated (credit
losses/capital), which are suitable for evaluating the impact of shock from a financial
stability point of view.

Stress Test Results

The final question that we seek to answer is to what extent each shock would undermine
the capital position of the banking industry. The loss measure is defined as follows:

(ELshock - ELbase) / Capital

Where EL is the `median' of the cumulated loss distribution. In the case of credit risk,
two basic risk measures are used: Expected and unexpected losses. The former is the
median or mean of losses and is supposed to be covered by provisioning. The unexpected
losses are to be backed by capital. The expected losses are taken in the baseline
scenario. As to the shocks, the expected losses conditional on the extreme realization of
the risk drivers are calculated. In the baseline scenario, we assume that banks always
provision enough to make up expected losses (they have enough profit, on the one hand,
and follow prudent provisioning on the other). Thus, to calculate the impact of the
shock, the difference between the EL in the shocked and the baseline scenario is taken.
These extra losses caused by the shock should be covered by capital.

The stress test results may reveal that the banking sector is robust and resilient to the
relevant shocks. Even a sharp decline in real GDP or an increase in foreign rates would,
at the most, cause an approximately 10% loss of capital and is within the prudential
limit.

Stress testing is introduced in India recently but the same has been introduced long
bank in the international market.

To explain that below mentioned is the case of Stress Testing in Nigerian Banks

WHAT IS STRESS TESTING?

Since the start of the global financial crisis, stress testing has received increased
attention by regulators, rating agents, bank management, etc. Stress testing is
not new. It has been a very important tool in the arsenal of risk management for
many years. However, banks have not been very successful in implementing
effective stress testing systems in the past. The reasons for this are lack of data,
complexity and quantitative models capability required and inability to
integrate the results of stress testing with the risk management decision process.

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Stress testing is the process of:

a. Defining potential extreme adverse future economic scenarios,

b. Measuring the sensitivity of the bank's credit, market, investment and

operational risk portfolios to changes in economic variables resulted under
extreme scenarios defined

c. Aggregating the results of b and quantifying the overall negative impact

on planned profitability, capital levels, liquidity position, etc.

d. Comparing the results of c to board approved risk appetite levels and

implementing risk reduction business strategies, policy changes, etc.
should the results of the stress test exceed risk appetite.

Step d is the most important in implementing an effective stress testing

framework. During the current global financial crisis, many international banks
ran into trouble because their stress testing frameworks omitted this important
step. Senior management failed to adjust their risk taking strategies and risk
management policies based on the stress testing results and continue to do
business as usual in the hope that the stress scenario will never realize. As we
now know, extreme scenarios have a habit of occurring more frequently than
popular belief, causing these banks to be bailed out to survive.

CHALLENGES IN IMPLEMENTING STRESS TESTING

The first and foremost challenge in implementing stress testing is the lack of
historical data to measure the impact of extreme stress events. As Nigeria has not
yet implemented global risk management standards, such as Basel II, which
requires banks to maintain elaborate loss histories, data availability for deriving
stress test impacts is limited. However, using appropriate statistical calibration
techniques and loss data from other emerging markets, this problem can be
overcome to derive plausible stress testing impacts for the Nigerian
environment.

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A second pre-requisite for a successful stress testing programme, is to have
board level approved risk appetite limits. These limits will drive the actions
required to reduce risks where the results of stress testing indicate excess risks.
Without such limits, no action will be taken.

To limit the negative potential future impact of stress scenarios, tough decisions,
sometimes with immediate negative revenue implications are required. Senior
management needs to take a strategic view and be prepared to position the
bank for long term sustainability and growth, sometimes at the expense of short
term revenue targets, if stress testing is to be effective.

TYPES OF STRESS TESTING

Nigerian banks should perform 3 types of stress testing as part of their on-going
stress testing framework execution. These are:

Moderate PBT stress.

This refers to the negative impact on planned PBT levels, due to moderate
stress scenarios – mild recession.

Liquidity stress test

This refers to the negative impact on liquidity levels, should extreme
liquidity events occur – large deposits outflows that cannot be replaced,
significant reduction in counterparty credit lines, etc.

Capital stress test

This refers to the impact on projected capital levels, should extreme
scenarios realize and large losses are incurred, eating into capital.

It is important that stress testing be performed bottom up – ie taking into

account the specific risk characteristics of loan portfolios, investments, collateral
holdings, business processes, etc. Top down stress testing with simplifying
assumptions about risks will lead to stress test results that are insufficiently
robust. Results of these stress tests should be used to adjust risk policies and
business strategies.

NIGERIAN CENTRAL BANK ROLE IN STRESS TESTING

One of the most severe early consequences of the global melt down after the

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collapse of Lehman Brothers in September 2008, was a freeze up of the inter
Bank markets worldwide, as confidence became impaired. Frozen inter-bank
Lending only started to thaw recently when regulators, lead by the US Federal
Reserve, implemented bank recapitalization based on the published results of
Stress testing.

A transparent system of standardized stress testing, lead by a central bank can

thus greatly restore and maintain confidence in country's banking system. One
lasting consequence of the global financial crisis will be an ongoing focus on
systemic stability – i.e. the robustness of the banking system to withstand severe
shocks. Stress testing has thus come to stay and the Nigerian banking industry
should start to incorporate stress testing as a crucial building block of the risk
management architecture.

Conclusions

I believe that the periodic application of stress-test scenarios must be

an integral part of a bank’s risk and management culture because they can
provide potential risk exposure assessments and support the capital planning
and the defining of alternative liquidity plans.

They can increase the endurance of banks and of the financial system
when faced with financial crises especially during stability/economic growth
periods, when, due to the lack of important risks, banks may not be aware of the
major impact crisis may have upon their financial stability and may accept
higher risks exposures more easily and with lower prices.

The importance of the stress-test was revealed by the amplitude and

duration of the ongoing financial crisis; in the same time, the need of improving
their effectiveness is driven by the fact that the crisis has overall proven to be
much more severe in terms of amplitude than the worst scenarios of many crisis
simulation systems.

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BIBLIOGRAPHY

http://www.rbi.org.in/home.aspx

www.thehindubusinessline.com/mentor/2005/12/26/stories/2005122601691000.htm

http://www.fisglobal.com/EMEA/BankingProducts/WholesaleBanking/TreasuryDealingRoomSystem/index.
htm

http://www.researchandmarkets.com/reports/c27974

http://www.indianbank.in/winser/image_newsletter.htm

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