Yesterday, the Basel Committee on Banking Supervision issued its "Principles for sound stress testing practices and supervision," following the Basel Committee's examination of stress test practices in the industry during the recent and ongoing economic crisis. The paper sets out a comprehensive set of principles for the sound governance, design and implementation of stress testing programs at banks, and comes on the heels of the Federal Reserve's publication of its "stress test" results for the 19 largest U.S. bank holding companies. According to the Committee, the financial crisis has highlighted weaknesses in stress testing practices employed prior to the start of the crisis in the following four broad areas:

  1. Use of stress testing and integration in risk governance - Stress testing practices at most banks 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." However those banks that were highly exposed to the financial crisis still "fared well" when senior management took an active interest in the development and operation of stress testing, as well as implementing the results of stress tests into strategic decision making.
  2. Stress testing methodologies - Most risk management models used historical statistical relationships to assess risk, "on the assumption that risk is driven by a known and constant statistical process." The problem with relying on this approach is that such risk management models do not account for "the possibility of severe shocks nor build up of vulnerabilities within the system." In addition, the failure to take a "comprehensive firm-wide perspective across risks" led to the failure of a "comprehensive view across credit, market and liquidity risks of their various businesses."
  3. Scenario selection - Most bank stress tests were not designed to capture "extreme market events" or match the bank's actual developments. Specifically, scenarios reflected only "mild shocks," shorter crisis durations and "underestimate[d] the correlations between different positions, risk types and markets." In addition banks that implemented hypothetical stress test scenarios "applied only moderate scenarios, either in terms of severity or the degree of interaction across portfolios or risk types," and those scenarios that may have been considered "extreme or innovative" were often "regarded as implausible by the board and senior management."
  4. Stress testing of specific risks and products - The Committee noted that the following particular risks were not covered in sufficient detail in most stress tests:
  • Behavior of complex structured products under stressed liquidity conditions - Stress tests of structured products failed to recognize that risk dynamics for structured instruments are different from those of similarly-rated cash instruments
  • Pipeline or securitization risk - Stress tests assumed that markets in structured products would remain liquid or, if impaired, for a short time period;
  • Basis risk in relation to hedging strategies;
  • Counterparty credit risk - Stress tests for counterparty credit risk "typically only stressed a single risk factor for a counterparty, were insufficiently severe and usually omitted the interaction between credit risk and market risk," rather stress tests should utilize "stresses applied across counterparties and to multiple risk factors";
  • Contingent risks - Stress test models did not "adequately capture contingent risks that arose either from legally binding credit and liquidity lines or from reputational concerns"; and
  • Funding liquidity risk - Stress tests "did not capture the systemic nature of the crisis or the magnitude and duration of the disruption to interbank markets."