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BaselCommitteeonBankingSupervisionConsultativeDocumentPrinciplesforsoundstresstestingpracticesandsupervisionIssuedforcommentby13March2009January2009Requestsforcopiesofpublications,orforadditions/changestothemailinglist,shouldbesentto:BankforInternationalSettlementsPress&CommunicationsCH-4002Basel,SwitzerlandE-mail:publications@bis.orgFax:+41612809100and+41612808100©BankforInternationalSettlements2009.Allrightsreserved.Briefexcerptsmaybereproducedortranslatedprovidedthesourceisstated.ISBNprint:92-9131-784-5ISBNweb:92-9197-784-5PrinciplesforsoundstresstestingpracticesandsupervisionTableofContentsIntroduction...............................................................................................................................7Performanceofstresstestingduringthecrisis.........................................................................8Useofstresstestingandintegrationinriskgovernance.................................................8Stresstestingmethodologies..........................................................................................9Scenarioselection.........................................................................................................10Specificrisks.................................................................................................................11Changesinstresstestingpracticessincetheoutbreakoftheturmoil...........................12Principlesforsoundstresstestingpracticesandsupervision................................................13Recommendationstobanks...................................................................................................13Useofstresstestingandintegrationinriskgovernance...............................................13Stresstestingmethodologyandscenarioselection......................................................16Specificareasoffocus..................................................................................................19Recommendationstosupervisors..........................................................................................21Principlesforsoundstresstestingpracticesandsupervision7PrinciplesforsoundstresstestingpracticesandsupervisionIntroductionThedepthanddurationofthefinancialcrisishasledmanybanksandsupervisoryauthoritiestoquestionwhetherstresstestingpracticesweresufficientpriortothecrisisandwhethertheywereadequatetocopewithrapidlychangingcircumstances.Inparticular,notonlywasthecrisisfarmoresevereinmanyrespectsthanwasindicatedbybanks'stresstestingresults,butitwaspossiblycompoundedbyweaknessesinstresstestingpracticesinreactiontotheunfoldingevents.Evenasthecrisisisnotoveryettherearealreadylessonsforbanksandsupervisorsemergingfromthisepisode.Stresstestingisanimportantriskmanagementtoolthatisusedbybanksaspartoftheirinternalriskmanagementand,throughtheBaselIIcapitaladequacyframework,ispromotedbysupervisors.Stresstestingalertsbankmanagementtoadverseunexpectedoutcomesrelatedtoavarietyofrisksandprovidesanindicationofhowmuchcapitalmightbeneededtoabsorblossesshouldlargeshocksoccur.Moreover,stresstestingisatoolthatsupplementsotherriskmanagementapproachesandmeasures.Itplaysaparticularlyimportantrolein:•providingforward-lookingassessmentsofrisk;•overcominglimitationsofmodelsandhistoricaldata;•supportinginternalandexternalcommunication;•feedingintocapitalandliquidityplanningprocedures;•informingthesettingofabanks’risktolerance;and•facilitatingthedevelopmentofriskmitigationorcontingencyplansacrossarangeofstressedconditions.Stresstestingisespeciallyimportantafterlongperiodsofbenigneconomicandfinancialconditions,whenfadingmemoryofnegativeconditionscanleadtocomplacencyandtheunderpricingofrisk.Itisalsoakeyriskmanagementtoolduringperiodsofexpansion,wheninnovationleadstonewproductsthatgrowrapidlyandforwhichlimitedornolossdataisavailable.Pillar1(minimumcapitalrequirements)oftheBaselIIframeworkrequiresbanksusingtheInternalModelsApproachtodeterminemarketriskcapitaltohaveinplacearigorousprogrammeofstresstesting.Similarly,banksusingtheadvancedandfoundationinternalratings-based(IRB)approachesforcreditriskarerequiredtoconductcreditriskstressteststoassesstherobustnessoftheirinternalcapitalassessmentsandthecapitalcushionsabovetheregulatoryminimum.BaselIIalsorequiresthat,ataminimum,bankssubjecttheircreditportfoliosinthebankingbooktostresstests.Recentanalysishasconcludedthatimplementationofthisrequirementwouldnothaveproducedlargelossnumbersinrelationtobanks’capitalbuffersgoingintothecrisisortheiractuallossexperience.Further,thegeneralstresstestsbanksarerequiredtoconductaspartofPillar2(supervisoryreviewprocess)mighthaveincludedmoreseverescenariosthantheonescurrentlyusedandproducedresultsmoreinlinewiththeactualstressesthatwereobserved.TheBaselCommitteehasengagedwiththeindustryinexaminingstresstestingpracticesoverthisperiodandthispaperistheresultofthatexamination.Notwithstandingtheongoingevolutionofthecrisisandfuturelessonsthatmayemerge,thispaperassessesstresstestingpracticesduringthecrisis.Basedonthatassessmentandinanefforttoi