- Our Ref:
- B1/15C
S4/14C
2 June 2009
The Chief Executive
All Authorized Institutions
Dear Sir / Madam,
Principles for sound stress testing
practices and supervision
The Basel Committee on Banking Supervision (BCBS) has recently
issued a set of Principles for Sound Stress Testing Practices and
Supervision, a copy of which is available on the Bank for
International Settlements' website at http://www.bis.org/publ/bcbs155.htm. I am
writing to draw your attention to these principles and the need for
authorized institutions to review their stress-testing practices in
the light of them.
Obviously, stress-testing is an important tool used by banks for
internal risk management and capital planning and it is also a key
component of the supervisory assessment process for evaluating the
capital adequacy of banks and identifying their vulnerabilities.
Summarised in the BCBS paper are various weaknesses in banks'
stress-testing practices revealed from the current financial
crisis, including -
- inadequate board and senior management oversight of the
stress-testing process;
- underestimation of the potential severity and duration of
stress events;
- inadequate account of system-wide interactions and feedback
effects caused by market reactions to stressed conditions;
- insufficient identification and aggregation of risks on a
firm-wide basis;
- various problems associated with stress-testing models and
methodologies; and
- inadequate coverage of risks arising from complex structured
products, pipeline or securitization risk, counterparty credit
risk, contingent risks and funding liquidity risk.
To address the above weaknesses, the BCBS guidance provides a
comprehensive set of principles for the sound governance, design
and implementation of stress-testing programmes at banks and sets
out expectations for the role and responsibilities of supervisors
in reviewing banks' stress-testing practices. Some key elements of
the principles applicable to banks are highlighted below:-
- Stress-testing should form an integral part of the overall
governance and risk management culture of a bank. It should be
actionable and impact on decision-making at the appropriate
management levels;
- Stress-testing programmes should promote risk identification
and control, provide a complementary risk perspective, improve
capital and liquidity management, and enhance internal and external
communication. Such programmes should also cover a range of
perspectives and techniques;
- Written policies and procedures, proper documentation, and
robust and flexible infrastructure in respect of stress-testing
should be in place;
- The stress-testing framework should be regularly maintained and
updated, with its effectiveness and robustness regularly and
independently assessed;
- Stress tests should cover a range of risks and business areas,
including at the firm-wide level, and be able to deliver a complete
picture of firm-wide risk;
- Stress-testing programmes should comprise scenarios along a
spectrum of events and severity levels, including forward-looking
scenarios, and aim to incorporate system-wide interactions and
feedback effects;
- The interaction of funding and asset markets as well as the
impact of a reduction in market liquidity should be taken into
account. The effectiveness of hedges and other risk mitigation
techniques should also be systematically challenged; and
- Stress-testing programmes should cover complex and bespoke
products such as securitized exposures, pipeline and warehousing
risks, reputation risk, risks arising from off-balance sheet
vehicles and related entities, and counterparty credit risk.
We support the principles set out in the BCBS paper, and believe
that their implementation in Hong Kong will help in further
enhancing the resilience of individual authorized institutions and
the banking system as a whole. While the existing guideline issued
by the HKMA (re: IC-5 "Stress-testing") broadly covers the major
aspects of stress-testing, there is scope for updating the
stress-testing standards to align them with the BCBS principles and
address the lessons drawn from the current crisis. We will aim to
enhance the guideline as soon as practicable and will consult the
industry on the proposed changes. In the meantime, authorized
institutions should review and strengthen, where necessary, their
stress-testing practices, taking into account the principles
contained in the BCBS guidance. The principles should be applied to
individual institutions on a proportionate basis, having regard to
their size, complexity and risk profile.
Yours faithfully,
Karen Kemp
Executive Director (Banking Policy)
- c.c.
- Chairman, Hong Kong Association of Banks
Chairman, DTC Association