127.In order to strengthen banks’ stress testing practices, as well as improve supervision of those practices, in October 2018 the Basel Committee published Principles for sound stress testing practices and supervision. Improvements in stress testing alone cannot address all risk management weaknesses, but as part of a comprehensive approach, stress testing has a leading role to play in strengthening bank corporate governance and the resilience of individual banks and the financial system.

128.Stress testing is an important tool that is used by banks as part of their internal risk management that alerts bank management to adverse unexpected outcomes related to a broad variety of risks, and provides an indication to banks of how much capital might be needed to absorb losses if large shocks occur. Moreover, stress testing supplements other risk management approaches and measures. It plays a particularly important role in:

1. i.Providing forward looking assessments of risk,
2. ii.Overcoming limitations of models and historical data,
3. iii.Supporting internal and external communication,
4. iv.Feeding into capital and liquidity planning procedures,
5. v.Informing the setting of a banks’ risk tolerance,
6. vi.Addressing existing or potential, firm-wide risk concentrations, and
7. vii.Facilitating the development of risk mitigation or contingency plans across a range of stressed conditions.

129.Stress testing is especially important after long periods of benign risk, when the fading memory of negative economic conditions can lead to complacency and the underpricing of risk, and when innovation leads to the rapid growth of new products for which there is limited or no loss data.

130.Stress testing must form an integral part of the overall governance and risk management culture of the bank. Board and senior management involvement in setting stress testing objectives, defining scenarios, discussing the results of stress tests, assessing potential actions and decision making is critical in ensuring the appropriate use of stress testing in banks’ risk governance and capital planning. Senior management must take an active interest in the development and operation of stress testing. The results of stress tests must contribute to strategic decision making and foster internal debate regarding assumptions, such as the cost, risk and speed with which new capital could be raised or that positions could be hedged or sold. Board and senior management involvement in the stress-testing program is essential for its effective operation.

131.Therefore, a bank’s capital planning process must incorporate rigorous, forward-looking stress testing that identifies possible events or changes in market conditions that could adversely have an impact on the bank. Banks, in their ICAAPs must examine future capital resources and capital requirements under adverse scenarios. In particular, the results of forward-looking stress testing must be considered when evaluating the adequacy of a bank’s capital buffer. Capital adequacy must be assessed under stressed conditions against a variety of capital ratios, including regulatory ratios. In addition, the possibility that a crisis impairs the ability of even very healthy banks to raise funds at reasonable cost must be considered.

132.In addition, a bank must develop methodologies to measure the effect of reputational risk arising from other risk types, namely credit, liquidity, market and other risks that they may be exposed to in order to avoid reputational damages and in order to maintain market confidence. This could be done by including reputational risk scenarios in regular stress tests. For instance, AML sanctions.

133.A bank must carefully assess the risks with respect to commitments to off-balance sheet vehicles and third-party firms related to structured credit securities and the possibility that assets will need to be taken on-balance sheet for reputational reasons. Therefore, in its stress-testing programme, a bank must include scenarios assessing the size and soundness of such vehicles and firms relative to its own financial, liquidity and regulatory capital positions. This analysis must include structural, solvency, liquidity and other risk issues, including the effects of covenants and triggers.

134.The Central Bank will assess the effectiveness of banks’ stress testing programme in identifying relevant vulnerabilities. The Central Bank will review the key assumptions driving stress-testing results and challenge their continuing relevance in view of existing and potentially changing market conditions. The Central Bank will challenge the banks on how stress testing is used and the way it affects decision-making. Where this assessment reveals material shortcomings, the Central Bank will require a bank to detail a plan of corrective action