Basel 3 June 2012


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Basel iii Compliance Professionals Association (BiiiCPA)

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Basel 3 June 2012

  1. 1. 1Basel iii Compliance ProfessionalsAssociation (BiiiCPA)1200G Street NW Suite800Washington, DC 20005-6705USA Tel:202-449-9750Web: www.basel-iii-association.comDear Member,Stresstestingisthemost important challengethismonth.PressReleasesBoard of Governorsof the Federal ReserveSystemFederal Deposit InsuranceCorporationOffice of the Comptroller of the CurrencyFor Immediate Release May 14, 2012Agencies Finalize Large Bank StressTesting GuidanceThe Federal ReserveBoard, the Office of the Comptroller of the Currency, and theFederal Deposit InsuranceCorporation on Monday issued final supervisory guidanceregardingstress-testingpractices at banking organizationswith total consolidatedassetsof more than $10billion.The guidance highlightsthe importance of stresstesting at banking organizationsasan ongoing risk management practicethat supports a banking organizationsforward-looking assessmentof its risks and better equips it to addressa range ofadverse outcomes.The recent financial crisisunderscored the need for banking organizationstoincorporate stresstesting into their risk management practices, demonstrating thatBasel iii ComplianceProfessionalsAssociation (BiiiCPA)
  2. 2. 2banking organizationsunprepared for particularly adverseeventsand circumstancescan suffer acute threats to their financial condition and viability.This guidance buildsupon previously issued supervisory guidance that discussestheusesand meritsof stresstesting in specific areasof risk management.The guidance outlinesgeneral principles for a satisfactorystresstesting frameworkand describesvariousstresstesting approaches and how stresstesting should be usedat variouslevelswithin an organization.The guidance alsodiscussesthe importance of stresstesting in capital and liquidityplanning and the importanceof strong internal governance and controlsaspart of aneffective stress-testingframework.The guidance does not implement the stresstesting requirements in the Dodd-FrankWall Street Reform and Consumer Protection Act (Dodd-Frank Act) or in the FederalReserveBoards capital plan rule that apply to certain companies, asthoserequirementshave been or are being implemented through separate proposals by therespective agencies.However, the agenciesexpect that banking organizationswith total consolidatedassetsof morethan$10billion would follow theprinciplesset forth in theguidance--aswell asother relevant supervisory guidance--whenconducting stresstesting inaccordancewith the Dodd-Frank Act, the capital plan rule, and other statutory orregulatoryrequirements.DEPARTMENT OF THE TREASURYOffice of the Comptroller of the CurrencyFEDERAL RESERVE SYSTEMFEDERAL DEPOSIT INSURANCE CORPORATIONSupervisory Guidance on StressTesting for BankingOrganizations with More Than $10Billion In TotalConsolidated AssetsAGENCIES: Board of Governorsof the Federal ReserveSystem (―Board‖ or―Federal Reserve‖);Federal Deposit InsuranceCorporation (―FDIC‖); Office of theComptroller of the Currency, Treasury(―OCC‖).Basel iii ComplianceProfessionalsAssociation (BiiiCPA)
  3. 3. 3ACTION: Final supervisory guidance.SUMMARY: The Board, FDIC and OCC, (collectively, the ―agencies‖) areissuing this guidance, which outlines high-level principles for stresstesting practices,applicable to all Federal Reserve-supervised, FDIC-supervised, and OCC-supervisedbanking organizationswith more than $10billion in total consolidated assets.The guidance highlightsthe importance of stresstesting asan ongoing riskmanagement practice that supports a banking organization‘s forward-lookingassessment of itsrisks and better equips the organization to addressa rangeofadverse outcomes.DATES: This guidance will becomeeffective on July 23, 2012.I. BackgroundOn June 15, 2011, the agencies requested public comment on joint proposed guidanceon the useof stresstesting asan ongoing risk management practiceby bankingorganizationswith more than $10billion in total consolidated assets(the proposedguidance).The public comment period on the proposedguidance closed on July 29,2011.The agencies areadopting the guidance in final form with certain modificationsthatarediscussedbelow (the final guidance).Asdescribed below, this guidance does not apply to banking organizationswithconsolidated assetsof $10billion or less.All banking organizations should have the capacityto understand their risks and thepotential impact of stressful eventsand circumstances ontheir financial condition.The agencieshavepreviously highlighted theuseof stresstesting asameansto betterunderstand the range of a banking organization‘s potential risk exposures.The 2007- 2009financial crisisfurtherunderscoredtheneedfor banking organizationsto incorporate stresstesting into their risk management, asbanking organizationsunprepared for stressful eventsand circumstancescan suffer acutethreatsto theirfinancial condition and viability.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)
  4. 4. 4The final guidanceisintendedto beconsistent with soundindustrypracticesandwithinternational supervisory standards.Building upon previously issued supervisory guidance that discussesthe usesandmeritsof stresstesting in specific areasof risk management, the final guidanceprovides principles that a banking organization should follow when conducting itsstresstesting activities.The guidance outlinesbroad principles for a satisfactorystresstestingframework and describesthe manner in which stresstesting should be employed asan integral component of riskmanagementthat isapplicable at variouslevels ofaggregation within a banking organization and that contributes to capital andliquidity planning.While the guidance is not intended to provide detailed instructionsfor conductingstresstesting for any particular risk or businessarea, the guidance describes severaltypesof stresstesting activitiesand how they may be most appropriately used bybanking organizationssubject to this guidance.The final guidance does not implement the stresstesting requirementsimposed bythe Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act)onfinancial companies regulated by theOCC, FDIC, orBoardwithtotal consolidatedassetsof morethan $10billion or bytheBoard‘scapital plan rule on U.S. bank holdingcompanieswith total consolidated assetsequal to or greater than $50billion.The Dodd-Frank Act‘s stresstesting requirementsarebeing implemented throughseparatenoticesof proposedrulemaking by the respective agencies.The Board issued the final capital plan rule on November 22, 2011.In light of theserecent rulemaking efforts on stresstesting, the guidance providesbanking organizationswith principles for conducting their stresstesting activities to,among other things, ensure that thoseactivitiesare adequately integratedinto overallrisk management.The agencies expectsuch companies would follow the principles set forth in theguidance – aswell asother relevant supervisory guidance – when conducting stresstesting in accordance with statutory or regulatory requirements.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)
  5. 5. 5II. Discussion of Comments on the Proposed GuidanceThe agencies received 17comment letterson the proposedguidance.Commentersincludedfinancial tradeassociations,bank holding companies, financialadvisory firms, and individuals. Commentersgenerally expressed support for theproposedguidance.However, several commentersrecommended changesto, or clarification of, certainprovisionsof the proposed guidance, asdiscussedbelow.In response to these comments, the agencies have clarified the principles set forth inthe guidance and modified the proposed guidance in certain respectsasdescribed inthis section.A. Scope of applicationThe proposed guidance would have applied to all banking organizationssupervised by the agencieswith more than $10billion in total consolidated assets.Specifically,- with respectto the OCC, thesebanking organizations would have includednational banking associationsand federal branchesand agencies;- with respect to the Board, these banking organizations would have included statemember banks, bank holding companies, and all other institutions for which theBoard is the primary federal supervisor;- with respectto the FDIC, thesebanking organizations would have included statenonmember banks and all other institutionsfor which the FDIC is the primaryfederal supervisor.The proposed guidance indicated that a banking organization shoulddevelop and implement itsstresstesting framework in a manner commensurate withitssize, complexity, business activities, and overall risk profile.Somecommenterssupported the total consolidated asset threshold (i.e., more than$10billion), but othersnoted the importance and value of stresstesting for smallerbanking organizations.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)
  6. 6. 6Consistent with the proposed guidance, no supervised banking organization with $10billion or lessin total consolidated assetsis subject to this final guidance.The agencies believe that $10billion is the appropriate threshold for the guidancebasedon the general complexity of firmsabove this size.However, the agencies note that previously issued supervisory guidance applicable toall supervised institutions discussesthe useof stresstesting asa tool in certain aspectsof risk management—such as for commercial real estate concentrations, liquidity riskmanagement, and interest-rate risk management.The agencies receivedtwo commentssuggesting that the $10billion totalconsolidated asset threshold be measuredover a four quarter period in order tominimize thelikelihood that temporaryasset fluctuationswould trigger application ofthe guidance.The agencies donot establish an asset calculation methodology in the final guidance;however, banking organizationswith assetsnear the threshold should usereasonablejudgment and consider, in conjunction with their primary federal supervisor asappropriate, whether they should consider preparing to follow the guidance.Threecommentersexpressedconcern that foreign banking organizations (FBOs) arerequired to follow stresstesting guidelines established by their home countrysupervisorsand suggestedthat theagenciesgive consideration to thoserequirements.When developing the guidance, the agenciessought to ensurethat it would notintroduce inconsistencieswith internationally agreedsupervisory standards.The agencies recognize that an FBO‘s U.S. operations are part of the FBO‘s globalenterprisesubject to requirementsof itshome country.The agencies provided sufficient flexibility in the proposedguidance sothat theguidance could apply to varioustypes of organizations.In this final guidance, the agencies clarify that certain aspectsof the guidance maynot apply to U.S. branchesand agencies of FBOs (such asthe portionsrelatedtocapital stresstesting) or may apply differently (such asportionsrelated to governanceand controls).Supervisorswill take theseissuesinto consideration when evaluating the ability ofU.S. offices of FBOs to meet the principles in the guidance.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)
  7. 7. 7Twocommentersexpressedconcern regarding the application of the proposedguidance to savingsand loan holding companies(SLHCs).They suggestedthat the Board issue separate guidance for SLHCs, astheseinstitutions would face adifferent set of stresstestingassumptionsand scenariosthanbanking organizations.The Board believes that the guidance is instructive to SLHCsto the samedegreeit isfor bank holding companies.The Federal Reserve became the primary federal supervisor for SLHCson July 21,2011, after the agencies published the proposed guidance for public comment butbefore the end of the comment period.While the Board recognizes that certain differencesdo exist betweenbank holdingcompanies and SLHCs, the Board believes the guidance containsflexibility adequateto accommodatethevariationsin size, complexity, businessactivities,and overall riskprofile of all banking organizationsthat meet the asset threshold.Thus, the guidance anticipatesthat each banking organization, including eachSLHC, would implement stresstesting in a manner consistent with itsown businessand risk profile.Similarly, one commenter advocated that the OCC proposeseparate guidance onstresstesting specifically tailored to savingsassociations.The OCC becamethe primary federal supervisor for federal savingsassociationsonJuly 21, 2011.While the OCC recognizesthat certain differencesdo exist betweennational banksand federal savings associations,the OCC notes that the final guidance containsflexibilityadequate to accommodate the variationsin size, complexity, businessactivities, and overall risk profile of all banking organizationsthat meet the assetthreshold.Thus, it is alsoexpectedthat eachfederal savingsassociation would implement theguidance consistent with itsown businessand risk profile.Several commentersrequestedclarification on the linkage between the stresstestingguidanceand the stresstesting requirementsin the Dodd-Frank Act.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)
  8. 8. 8In devising the guidance, the agenciesendeavored to ensure that the proposedandfinal guidance is consistent with the stresstesting requirementsunder theDodd-Frank Act and believe that the principles set forth in the final guidance areuseful when conducting the stresstestsrequired under theAct.Notably, the final guidance was framed broadly to inform a banking organization‘suse of stresstesting in overall risk management, not just stresstests required underthe Dodd-Frank Act.Dodd-F rank stress tes ts would generally be con sidered part o f anorgan ization‘s overall stresstesting framework asdescribed in thestresstesting guidance.B. StressTesting PrinciplesAsnoted above, the proposed guidance identified and included a discussion of fourkeyprinciples for a banking organization‘s stresstesting framework and relatedstresstest results, namely that:(1)Abanking organization‘s stresstesting framework should include activitiesandexercises that are tailored to and sufficiently capture the banking organization‘sexposures, activities, and risks;(2)An effective stresstesting framework employs multiple conceptually sound stresstesting activities and approaches;(3) An effective stresstesting framework is forward-looking and flexible; and(4)Stresstest resultsshould be clear, actionable, well supported, and informdecision-making.In the final guidance, the agencieshave incorporated a fifth principle specifying thatan organization‘s stresstesting framework should include strong governance andeffective internal controls.The elementsof the fifth principle had been set forth in sectionVI of the proposedguidance, and the fifth principle doesnot expand on this aspect of the proposedguidance.Rather, the agencies reorganized this discussion into a fifth principleBasel iii ComplianceProfessionalsAssociation (BiiiCPA)
  9. 9. 9in order to underscorethe importance of governance and controls asa key element ina banking organization‘sstresstesting framework.Asnoted above, commentersweresupportive of the principles-based approachandthe notion that a banking organization‘s stresstesting framework should beimplemented in amanner commensurate with factorssuchasthecomplexityand sizeof the organization.With more specific regard to the proposed principles, commenterssuggested that thefinal guidance addressthe standardization of stresstesting through the inclusion ofcommoncoefficients, models, or benchmarks.Thesecommentersexpressedconcernsthat banking organizationswould implementthe principles inconsistently and that standardization would help regulatorsconductcomparative analysesacrossfirms.Another commenter suggested that the agencies prescribe more detailed andintegrated stresstesting between different entities or businessunitswithin anorganization.The agencies did not modify the guidance in responseto thesecomments.Akey aspectof theguidanceis to provide organizationsflexibilityon how theydesigntheir individual stresstesting frameworks.Thus, each banking organization should design a specific stresstesting framework tocapturerisksrelevant to the organization.The agenciesbelieve that prescribingstandardized stresstestsin this guidancewouldhave its own inherent limitations and may not appropriately cover a bankingorganization‘s material risks and activities.In addition, commenterssuggested that the agenciesmandate public releaseofstresstesting resultsthrough the guidance.The agencies haveconsideredthesecomments, but do not believe the final guidanceis the appropriate place for such a requirement given itsbroader focus on bankingorganizations‘overall stresstesting frameworks.The agencies note, however, that banking organizationsmay be required to discloseinformation about their stresstests pursuant to other statutory, regulatory, orsupervisory requirements.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)
  10. 10. 10Afew commentersstated that a banking organization should explain and justify thestresstesting methodologies it utilizes to itsprimary federal supervisor.The agencies note that supervisorswill examinefirms‘stresstesting methodologiesthrough the supervisory process.One commenter noted that the guidance should explicitly indicate that liabilitiesshould be part of a banking organization‘s stresstesting activities; the agenciesintended that stresstesting activities would takean organization‘s liabilities intoaccount and have clarifiedthis in the final guidance.Threecommenterssuggestedthat operational risk be specifically referencedin theguidance.In response,the agencieshave clarified in the final guidance that operational riskshouldbe among the risksconsideredby an organization‘s stresstestingframework.Another commenter expressed concern that the frequency of stresstesting andcommunication of resultsmight eventually desensitize senior management to them.The agenciesbelieve that regular review of stresstest resultsis useful – both duringperiodsof economic downturn and benign periods– and have clarified that suchreview can help a banking organization track over time the impact of ongoingbusinessactivities, changesin exposures, varying economic conditions, and marketmovementson itsfinancialcondition.Aside from the inclusion of a fifth principle asdescribedabove, the agencies haveotherwiseadopted the proposed principles in the final guidance with only minoradditional refinements.C. Stresstesting approachesand applicationsThe proposed guidance describedcertain stresstesting approaches andapplications– scenario analysis, sensitivity analysis, enterprise-wide testing, andreversestresstesting – that a banking organization could consider using within itsstresstesting framework, asappropriate.The proposed guidance provided that each banking organization should apply theseapproaches and applicationscommensurate with itssize, complexity, and businessprofile, and may not need to incorporate all of the details described in the guidance.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)
  11. 11. 11Somecommentersquestioned the appropriatenumber and typesof stresstestapproaches an organization should utilize.The agencies donot believe that specifying a number or particular typesofapproaches–including thenumberof scenarios–isappropriatein theguidancegiventhe wide range of stresstesting activities that different banking organizationsmayundertake.Abanking organization should choosethe approaches that appropriatelyconsider theunique characteristics of that particular organization and the relevant risksit faces.The agencies expectthat stresstesting methodologies will evolve over time asbanking organizationsdevelop approaches that best capture their individual riskprofiles.In addition, the proposed guidance described reversestresstesting asa tool thatwould allow a banking organization to assumea known adverse outcome, such assuffering a credit lossthat causesit to breach a minimum regulatory capital ratio orsuffering severe liquidity constraintsmaking it unable to meet its obligations, andthen deduce the typesof eventsthat could lead to such an outcome.This type of stresstesting may help a banking organization to consider scenariosbeyond itsnormal businessexpectationsand seetheimpact of severesystemic effectson the banking organization.It also would allow a banking organization to challengecommon assumptionsaboutitsperformanceand expected mitigation strategies.Three commenters expressed doubts regarding the effectiveness of reverse stresstesting, as the approach could produce resultsof questionable value and capturesunlikely, ―extreme‖ scenarios.The agencies reiterate the value of reversestresstesting, asit helpsa bankingorganization evaluate the combined effect of several typesof extremeeventsandcircumstancesthat might threaten the survival of the banking organization, even if inisolation eachof the effects might be manageable.Another commenter expressedconcern that the resultsof severescenariosused forreversestresstesting would directly lead to a supervisory requirement to raise capitalif the resultsof the approach were unfavorable to the organization.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)
  12. 12. 12In addition, some commenterssought clarification that resultswould not be used byregulatorsto criticize banking organizations.As stated in the proposed guidance, a given stress test result will not necessarily leadto immediate action by a firm, and in some casesstress test results – including thosefrom reversestresstests – aremost useful for the additional information they provide.In termsof supervisory responsesto an organization‘s stresstesting activities, theagencies expectto consider a banking organization‘s stresstest resultsand theappropriatenessof itsoverall stresstesting framework, along with all other relevantinformation, in assessingabanking organization‘s riskmanagement practices, aswellasitscapital and liquidity adequacy.The guidance setsforth supervisory expectationsfor prudent risk managementpractices and a firms decision not to follow the principles in this guidance will beexaminedaspart of the supervisory processand maybe cited asevidence of unsafeand unsound practices.D. Stresstesting for assessing adequacy of capital and liquidityGiven the importance of capital and liquidity to a banking organization‘sviability,stresstesting should be applied to thesetwo areason a regular basis.Stresstesting for capital and liquidity adequacyshould be conducted in coordinationwith a banking organization‘s overall businessstrategy and annual planning cycles.Resultsshould be refreshedin theevent of major strategic decisions, or other changesthat can materially impact capital or liquidity.An effective stresstesting framework should explorethe potential for capital andliquidity problemsto ariseat the sametime or exacerbateone another.Abanking organization‘sliquidity stressanalysis should explore situationsin whichthe banking organization maybe operating with a capital position that exceedsregulatoryminimums, but is nonethelessviewed within thefinancial marketsor by itscounterpartiesasbeing of questionable viability.For itscapital and liquidity stresstests, a banking organization should articulateclearlyitsobjectivesfor apost-stressoutcome, forinstanceto remain aviablefinancialmarket participant that is able to meet itsexisting and prospective obligationsandcommitments.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)
  13. 13. 13In responseto comments received on the planning horizon for stresstests, theagencies clarifiedthat whilecapital stresstestsshould generally be conducted with ahorizon of at least two years, organizationsshould recognize that the effectsof certainstressconditionscould extend beyond that horizon.The agencies havealsoclarified, in responseto comments, that consolidated stresstests should account for the fact that certain legal entities within the consolidatedorganization arerequired to meet regulatorycapital requirements.Acommenter requested clarification on whether capital and liquidity stresstestingshould be evaluated in unified or separate stresstests.The proposed guidance did not specify the precisemanner in which capital andliquidity stresstestsshould be performed.The final guidance notes that assessing the potential interaction of capital andliquidity can be challenging and maynot be possible within a single stresstest, soabanking organization should explore several avenuesto assessthat interaction.In any case, the agenciesbelievethat stresstesting for both liquidity and capitaladequacyshould be an integral part of a banking organization‘s stresstestingframework.E. Governance and controlsAsnoted under the new fifth principle of the final guidance, a bankingorganization‘s stresstesting framework will be effective only if it issubject to stronggovernanceand controlsto ensure that the framework functionsasintended.Strong governance and controls alsohelp ensure that the framework contains coreelements, from clearly defined stresstesting objectives to recommended actions.Importantly, strong governance provides critical review of elementsof the stresstesting framework, especially regarding key assumptions, uncertainties, andlimitations.Abanking organization should ensurethat thestresstesting framework isnot isolatedwithin a banking organization‘s risk management function, but is firmly integratedintobusiness lines, capital and asset-liabilitycommittees, and other decision-makingbodies.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)
  14. 14. 14Aspart of their overall responsibilities, a banking organization‘s board and seniormanagementshould establish acomprehensive, integratedand effective stresstestingframework that fits into the broader risk management of the banking organization.Stresstesting resultsshould be used to inform the board about alignment of thebanking organization‘s risk profile with the board‘s chosen risk appetite, aswell asinform operating and strategic decisions.Stresstesting resultsshould be considered directly by the board and seniormanagement for decisions relating to capital and liquidity adequacy.Senior management, in consultation with the board, should ensure that the stresstesting framework includesa sufficient rangeof stresstesting activities applied at theappropriatelevels of thebanking organization (i.e., not just oneenterprise-widestresstest).Several commentersraised concernsregarding the proposedresponsibilities of abanking organization‘s board of directorswith respectto stresstests and theframework.One commenter believed that the board of directorsshould not review all stresstestresults, but rather only thosethat wereexpected to have a material impact on theoverall organization.Another commenter expressed the belief that the board of directorsshould beinvolved in providing direction and oversight regarding the banking organization‘sstresstesting framework, but that the board of directorsshould not be expectedto beinvolved directly in more operational aspectsof the framework.The agencies havemodified the final guidance to clarify that senior management, notthe board of directors, should have the primary responsibilityfor stresstestingimplementation and technical design.However, the agenciesemphasize that a banking organization‘s board of directorsshould be provided with information from senior management on stresstestingdevelopments(including the processto design tests and develop scenarios) and onstresstesting results(including from individual tests, wherematerial).Asa general matter, the board of directorsis alsoresponsible for monitoringeffectiveness of the overall framework, and using the resultsto inform their decisionmaking process.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)
  15. 15. 15In addition, the final guidance specifiesthat senior management should, inconsultation with the board of directors, review stresstesting activities and resultswith an appropriately critical eye to ensure that thereis objective review and that thestresstesting framework includesa sufficient range of stresstesting activitiesappliedat the appropriate levels of the banking organization.Finally, in responseto comments, the agencies have clarified that a bankingorganization‘s minimum annual review and assessmentof the effectivenessof theirstresstesting framework should ensure that stresstesting coverage is comprehensive,tests are relevant and current, methodologies aresound, and resultsare properlyconsidered.IV. Administrative Law MattersA. Paperwork ReductionAct AnalysisIn accordance with the Paperwork Reduction Act (―PRA‖) of 1995 the agenciesreviewed the final guidance. The agencies may not conduct or sponsor, and anorganization is not required to respond to, an information collection unless theinformation collection displays a currently valid OMB control number.While the guidance is not being adopted asa rule, the agenciesdetermined thatcertain aspectsof the guidance may constitute a collection of information and,therefore, believed it washelpful to publish a burden estimate with the guidance.In particular, the aspectsof the guidance that mayconstitute an informationcollection are the provisions that state a banking organization should(i)Havea stresstesting framework that includesclearly defined objectives,well-designedscenarios tailored to the banking organization‘s businessand risks,well-documentedassumptions, conceptually sound methodologies to assesspotentialimpact on the banking organization‘s financial condition, informative managementreports, and recommendedactionsbased on stresstest results;and(ii)Havepolicies and proceduresfor a stresstesting framework.The agenciesestimated that the above-described information collectionsincluded inthe guidance would takerespondents, on average, 260hourseach year.The frequency of information collection is estimatedto be annual. Respondentsarebanking organizationswith more than $10billion in total consolidated assets, asdefined in the guidance.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)
  16. 16. 16The agencies receivedthree comment lettersregarding the paperwork burden of theguidance, stating that implementation will require a multiple of the 260estimatedhours.The agencies emphasize that the guidance doesnot implement the stresstestingrequirementsimposedby the Dodd-Frank Act or the Board‘s capital plan rule, anddoesnot otherwiseimposemandatorystresstesting requirements.The burden of information collections associatedwith mandatory stresstestswill beaccountedfor in the respective rules that implement thoserequirements.In addition, the agenciesbelieve that in somerespects, the information collectionelements of this guidance augment certain expectationsthat already are in placerelative to certain existing supervisory guidance.The burden estimatesfor this guidance take into consideration only thosecollectionsof information, such asdocumentation of policiesand proceduresand relevantreports, that are specific to this guidance.Basedon these factors, the agencies believe the burden estimatesincluded in theproposedguidance continue to be appropriate.V. Final supervisory guidanceThe text of the final supervisory guidance is asfollows:Office of the Comptroller of the CurrencyFederal ReserveSystemFederal Deposit InsuranceCorporationGuidance on StressTesting for Banking Organizations withTotal Consolidated Assets of More Than $10BillionI. IntroductionAll banking organizations should have the capacityto understand fully their risksandthepotential impactof stressfuleventsand circumstancesontheirfinancial condition.The U.S. federal banking agencies have previously highlighted the useof stresstesting asa meansto better understand the rangeof a banking organization‘spotential risk exposures.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)
  17. 17. 17The 2007-2009 financial crisis underscored the need for banking organizationstoincorporate stresstesting into their risk management practices, demonstrating thatbanking organizationsunprepared for stressful eventsand circumstancescan sufferacutethreatsto their financial condition and viability.The Federal Reserve, the Office of the Comptroller of the Currency, and the FederalDeposit InsuranceCorporation (collectively, the ―agencies‖) are issuing thisguidance to emphasize the importanceof stresstesting asan ongoing riskmanagement practice that supports banking organizations‘forward-lookingassessment of risksand better equips them to addressa range of adverseoutcomes.This joint guidance is applicable toall institutionssupervised by the agencies withmore than $10billion in total consolidated assets.Specifically, with respect to the OCC, thesebanking organizationsinclude nationalbanking associations, federal savings associations,and federal branchesandagencies;with respectto the Board, these banking organizationsinclude statemember banks, bank holding companies, savings and loan holding companies, andall other institutionsfor which the Federal Reserveis the primaryfederal supervisor;with respectto the FDIC, these banking organizations include state nonmemberbanks, state savings associationsand insured branches of foreign banks.The guidance doesnot apply to any supervisedinstitution below the designated assetthreshold.Certain other existing supervisoryguidance that applies to all supervised institutionsdiscussestheuseof stresstesting asa tool in certain aspects of risk management,such asfor commercial real estate concentrations, liquidity risk management, andinterest-rate risk management.However, noinstitution at orbelow $10billion in total consolidatedassetsis subjecttothis final guidance.Building upon previously issued supervisory guidance that discussesthe usesandmeritsof stresstesting in specific areasof risk management, this guidance providesbroad principles a banking organization should follow in conducting its stresstestingactivities, such asensuring that thoseactivitiesfit into the organization‘soverall riskmanagement program.The guidanceoutlinesbroadprinciplesfor a satisfactorystresstesting framework anddescribesthe manner in which stresstesting should be employed asan integralcomponent of risk management that isapplicable at variouslevelsof aggregationBasel iii ComplianceProfessionalsAssociation (BiiiCPA)
  18. 18. 18within a banking organization, aswell asfor contributing to capital and liquidityplanning.While the guidance is not intended to provide detailed instructionsfor conductingstresstesting for any particular risk or businessarea, the document describes severaltypesof stresstesting activitiesand how they maybe most appropriately used bybanking organizations.II. Overview of StressTesting FrameworkFor purposesof this guidance, stresstesting refersto exercisesused to conduct aforward looking assessment of the potential impact of variousadverse eventsandcircumstances ona banking organization.Stresstesting occursat variouslevelsof aggregation, including on an enterprise-widebasis.Asoutlined in section IV, thereare several approachesand applicationsfor stresstesting and a banking organization should consider the useof eachin itsstresstesting framework.An effective stresstesting framework provides a comprehensive, integrated, andforwardlooking set of activities for a banking organization to employalong with otherpractices in order to assist in the identification and measurement of its material risksand vulnerabilities, including thosethat maymanifest themselves during stressfuleconomic or financial environments, or arise from firm-specificadverseevents.Sucha framework should supplement other quantitative risk management practices,suchasthosethat rely primarily on statistical estimatesof risk or lossestimatesbasedon historical data, aswell asqualitative practices.Inthismanner, stresstestingcanassist in highlighting unidentified orunder-assessedrisk concentrationsand interrelationships and their potential impact on the bankingorganization during timesof stress.Abanking organization should develop and implement itsstresstesting framework ina manner commensurate with its size, complexity, businessactivities, and overall riskprofile.Its stresstesting framework should include clearly defined objectives, well-designedscenarios tailored to the banking organization‘s businessand risks, well-documentedBasel iii ComplianceProfessionalsAssociation (BiiiCPA)
  19. 19. 19assumptions, sound methodologies to assesspotential impact on the bankingorganization‘s financial condition, informative management reports, ongoing andeffective review of stresstesting processes,and recommendedactionsbasedon stresstest results.Stresstesting should incorporate the useof high-quality data and appropriateassumptionsabout the performance of the institution under stressto ensure that theoutputsarecredible and can be used to support decision-making.Importantly, a banking organization should have a sound governanceand controlinfrastructure with objective, critical review to ensurethe stresstesting framework isfunctioning asintended.Astresstestingframework shouldallow abanking organizationto conduct consistent,repeatable exercisesthat focus on its material exposures, activities, risks, andstrategies, and alsoconduct ad hoc scenariosasneeded.The framework should consider the impact of both firm specificand systemic stresseventsand circumstancesthat arebased on historical experience aswell asonhypothetical occurrencesthat could have an adverseimpact on a bankingorganization‘s operations and financial condition.Banking organizationssubject to this guidance should develop policies on reviewingand assessing the effectivenessof their stresstesting frameworks,and usethosepolicies at leastannually to assessthe effectivenessof their frameworks.Suchassessmentsshould help to ensure that stresstesting coverageiscomprehensive, tests are relevant and current, methodologies are sound, and resultsareproperly considered.III. General StressTesting PrinciplesAbanking organization should develop and implement an effective stresstestingframework aspart of its broader risk management and governance processes.The framework should include severalactivitiesand exercises, and not just relyonanysingle test or type of test, since every stresstest haslimitations and relieson certainassumptions.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)
  20. 20. 20The usesof a banking organization‘s stresstesting framework should include, but arenot limited to,- augmenting risk identification and measurement;- estimating businessline revenuesand lossesand informing businesslinestrategies;- identifying vulnerabilities, assessing the potential impact from thosevulnerabilities, and identifying appropriate actions;- assessing capital adequacyand enhancing capital planning; assessing liquidityadequacyand informing contingency funding plans;- contributing to strategic planning;- enabling senior management to better integrate strategy, risk management, andcapital and liquidity planning decisions; and assistingwith recoveryandresolutionplanning.This section describes general principles that a banking organization should apply inimplementing such a framework.Principle 1:A banking organization‘s stress testing framework should include activities andexercises that are tailored to and sufficiently capture the banking organization‘sexposures, activities, and risks.An effective stresstesting framework coversa banking organization‘s full set ofmaterial exposures, activities, and risks, whether on or off the balancesheet, basedoneffective enterprise-widerisk identification and assessment.Risksaddressedin a firm‘s stresstesting framework mayinclude (but are not limitedto) credit, market, operational, interest-rate, liquidity, country, and strategic risk.The framework should also addressnon-contractual sourcesof risks, such asthoserelated to a banking organization‘s reputation.Appropriate coverage is important asstresstesting resultscould give a false senseofcomfort if certain portfolios, exposures, liabilities, or businessline activitiesare notincluded.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)
  21. 21. 21Stresstesting exercisesshould be part of a banking organization‘s regular riskidentification and measurementactivities.For example, in assessingcredit risk a banking organization should evaluate thepotential impact of adverseoutcomes, such asan economic downturn or decliningasset values, on the condition of its borrowersand counterparties, and on the value ofany supporting collateral.Asanother example, in assessing interest-raterisk, banking organizations shouldanalyze the effects of significant interest rate shocks or other yield-curve movements.An effective stresstesting framework should be applied at variouslevelsin thebanking organization, such asbusinessline, portfolio, and risk type, aswell ason anenterprise-wide basis.In many cases, stresstesting may be moreeffectiveat businessline and portfoliolevels, asa higher level of aggregation may cloud or underestimate the potentialimpact of adverse outcomeson a banking organization‘s financial condition.In somecases,stresstesting can also be applied to individual exposuresorinstruments.Eachstresstest should be tailored to the relevant level of aggregation, capturingcritical risk drivers, internal and external influences,and other key considerationsatthe relevant level.Stresstesting should capturethe interplay among different exposures, activities, andrisksand their combined effects.While stresstesting several typesof risks or business linessimultaneously may proveoperationally challenging, abanking organization should aim to identify commonriskdrivers acrossrisk types and businesslines that can adverselyaffect itsfinancialcondition.Accordingly, stresstests should provide a banking organization with the ability toidentify potential concentrations – including thosethat may not be readily observableduring benign periodsand whose sensitivity to a common set of factorsis apparentonly during timesof stress– and to assessthe impact of identified concentrations ofexposures, activities, and riskswithin and acrossportfoliosand businesslinesand onthe organization asa whole.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)
  22. 22. 22Stresstesting should be tailored to the banking organization‘s idiosyncrasies andspecificbusinessmix and include all major business linesand significant individualcounterparties.For example, a banking organization that isgeographically concentrated maydetermine that a certain segment of itsbusiness maybe more adverselyaffectedbyshocksto economic activity at the state or local level than by a severe nationalrecession.On the other hand, if the banking organization hassignificant global operations, itshould consider scenariosthat have an international component and stressconditionsthat could affect the different aspectsof itsoperations in different ways, aswell asconditionsthat could adverselyaffect all of its operations at the sametime.A banking organization should use its stress testing framework to determine whetherexposures, activities, and risks under normal and stressed conditionsare aligned withthe banking organization‘s risk appetite.Abanking organization can usestresstesting to help inform decisions about itsstrategic direction and/ or risk appetite by better understanding the risksfrom itsexposuresorof engaging in certain businesspractices.For example, if a banking organization pursuesa businessstrategyfor a new ormodified product, and the banking organization doesnot have long-standingexperience with that product or lacks extensivedata,the banking organization can usestresstesting to identify the product‘s potentialdownsides and unanticipated risks.Scenarios used in a banking organization‘s stresstestsshould be relevant to thedirection and strategy set by itsboard of directors, aswell assufficiently severe to becredible to internal and external stakeholders.Principle 2:An effective stresstesting framework employsmultiple conceptually sound stresstesting activities and approaches.All measuresof risk, including stresstests, have an elementof uncertaintydue toassumptions, limitations, and other factorsassociatedwith using past performancemeasuresand forward-looking estimates.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)
  23. 23. 23Banking organizationsshould, therefore, usemultiple stresstesting activities andapproaches (consistent with section IV), and ensure that eachis conceptually sound.Stresstestsusually varyin design and complexity, including the number of factorsemployed and the degreeof stressapplied.Abanking organization should ensure that the complexity of any given test doesnotundermine itsintegrity, usefulness, or clarity.In somecases, relativelysimple testscan be very useful and informative. Additionally,effective stresstesting relies on high-quality input data and informationto produce credible outcomes.A banking organization should ensure that it hasreadily available data and otherinformation for the types of stress tests it uses, including key variables that driveperformance.In addition, a banking organization should have appropriate managementinformation systems(MIS) and data processesthat enable it to collect, sort,aggregate, and update data and other information efficiently and reliably withinbusinesslines and acrossthe banking organization for usein stresstesting.If certain data and information are not current or not available, or if proxies are used, abanking organization should analyze the stresstest outputs with an understanding ofthosedata limitations.Abanking organization should alsodocument the assumptionsused in itsstresstestsand note the degreeof uncertainty that maybe incorporated into the tools used forstresstesting.In somecases, it maybe appropriate to present and analyze test resultsnot just intermsof point estimates,but also including the potential margin of error or statisticaluncertaintyaround the estimates.Furthermore, almost all stresstests, including well-developed quantitative testssupported by high-quality data, employ a certain amount of expert or businessjudgment, and the role and impact of such judgment should be clearly documented.In somecases,when credible data are lacking and more quantitative tests areoperationally challenging or in the early stagesof development, a bankingBasel iii ComplianceProfessionalsAssociation (BiiiCPA)
  24. 24. 24organization may choose to employ more qualitatively based tests, provided that thetests are properly documented and their assumptionsaretransparent.Regardlessof the type of stresstests used, a banking organization should understandand clearly document all assumptions, uncertainties, and limitations, and provide thatinformation to usersof the stresstesting results.Principle 3:An effective stresstesting framework is forward-looking and flexible.Astresstesting framework should be sufficiently dynamic and flexible to incorporatechangesin a banking organization‘s on- and off-balance-sheet activities, portfoliocomposition, asset quality, operating environment, businessstrategy, and other risksthat mayariseover time from firm-specificevents, macroeconomic and financialmarket developments, or some combination of theseevents.Abanking organization should also ensure that itsMISare capable of incorporatingrelatively rapid changesin exposures, activities, and risks.While stresstesting should utilize available historical information, a bankingorganization should look beyond assumptionsbased only on historical data andchallengeconventional assumptions.Abanking organization should ensure that it is not constrained by past experienceand that it considersmultiple scenarios, even scenarios that have not occurredin therecent past or during the banking organization‘shistory.For example, a banking organization should not assumethat if it hassuffered no orminimal lossesin a certain businessline or product that such a pattern will continue.Structural changesin customer, product, and financial marketscanpresentunprecedented situations for a banking organization.Abanking organization with any type of significant concentration can be particularlyvulnerable to rapid changesin economic and financial conditionsand should trytoidentify and better understand the impact of thosevulnerabilitiesin advance.For example, the risksrelated to residential mortgageswere underestimatedfor anumber of yearsleading up to the 2007-2009financial crisis by a large number ofbanking organizations, and thoserisks eventually affectedthe banking organizationsin a variety of ways.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)
  25. 25. 25Effective stresstesting can help a banking organization identify any suchconcentrationsand help understand the potential impact of several key aspectsof thebusinessbeing exposedto common drivers.Stresstesting should be conducted over various relevant time horizonsto adequatelycapture both conditionsthat may materialize in the near term and adverse situationsthat take longer to develop.For example, when a banking organization stresstests a portfolio for market andcredit risks simultaneously, it should consider that certain credit risk lossesmay takelonger to materialize than market risk losses, and alsothat the severity and speed ofmark-to-market lossesmay createsignificant vulnerabilitiesfor the firm, even if amore fundamental analysis of how realized lossesmay play out over time seemstoshow lessthreatening results.Abanking organization should carefully consider the incremental and cumulativeeffectsof stressconditions, particularly with respectto potential interactionsamongexposures, activities, and risksand possible second-order or ―knock-on‖ effects.In addition to conducting formal, routine stresstests, a banking organization shouldhavetheflexibility to conduct new or ad hoc stresstestsin a timely mannerto addressrapidly emerging risks.Theselessroutine tests usually can be conducted in a short amount of time and maybe simpler and lessextensivethan a banking organization‘s more formal, regulartests.However, for its ad hoc tests a banking organization should still have the capacitytobring together approximated information on risks, exposures, and activities andassesstheir impact.More broadly, a banking organization should continue updating and maintaining itsstresstesting framework in light of new risks, better understanding of the bankingorganization‘s exposuresand activities, new stresstestingtechniques, and anychangesin itsoperating structureand environment.Abanking organization‘sstresstesting development should beiterative, with ongoingadjustmentsand refinementsto better calibratethe tests to provide current andrelevant information.Banking organizationsshould document the ongoing development of their stresstesting practices.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)
  26. 26. 26Principle 4:Stresstest resultsshould be clear, actionable, well supported, and informdecision-making.Stresstesting should incorporate measuresthat adequately and effectively conveyresultsof the impact of adverse outcomes.Suchmeasuresmayinclude, for example, changesto asset values, accounting andeconomic profit and loss, revenue streams, liquidity levels, cash flows, regulatorycapital, risk-weightedassets,the loan lossallowance, internal capital estimates, levelsof problem assets, breachesin covenantsor keytrigger levels, or other relevantmeasures.Stresstest measuresshould be tailored to the type of test and the particular level atwhich the test isapplied (for example, at the businessline or risk level). Some stresstests mayrequire using a range of measuresto evaluate the full impact of certainevents, such asa severesystemic event.In addition, all stresstest resultsshould be accompanied by descriptive andqualitative information (such askey assumptionsand limitations) to allow userstointerpret the exercisesin context.The analysis and the processshould be well documented sothat stresstestingprocessescan be replicatedif need be.Abanking organization should regularly communicate stresstest resultstoappropriate levels within the banking organization to foster dialogue around stresstesting, keep the board of directors,management, and staff apprised, and to informstresstesting approaches, results, and decisions in other areasof the bankingorganization.Abanking organization should maintain an internal summaryof test resultstodocument at a high level therangeof itsstresstesting activitiesand outcomes, aswellasproposedfollow-up actions.Regular review of stresstest resultscan be an important part of a bankingorganization‘s ability over time to track the impact of ongoing businessactivities,changesin exposures, varying economic conditions, and market movementson itsfinancial condition.In addition, management should review stresstesting activities on a regular basis todetermine, among other things, the validity of the assumptions, the severityof tests,Basel iii ComplianceProfessionalsAssociation (BiiiCPA)
  27. 27. 27the robustnessof the estimates, the performanceof any underlying models, and thestability and reasonablenessof the results.Stresstest resultsshould inform analysis and decision-making related to businessstrategies, limits, risk profile, and other aspectsof risk management, consistent withthe banking organization‘s established risk appetite.Abanking organization should review the resultsof itsvariousstresstests with thestrengthsand limitationsof each test in mind (consistent with Principle 2),determines which resultsshould be given greater or lesser weight, analyze thecombined impact of its tests, and then evaluate potential coursesof action based onthat analysis.Abanking organization may decide to maintain itscurrent coursebased on testresults;indeed, the resultsof highly severe stresstests need not alwaysindicate thatimmediateactionhas to be taken.Wherever possible, benchmarking or other comparative analysis should be used toevaluatethe stresstesting resultsrelative to other tools and measures– both internaland external to the banking organization – to provide proper context and a check onresults.Principle 5:An organization‘s stresstesting framework should include strong governance andeffective internal controls.Similar to other aspectsof itsrisk management, a banking organization‘sstresstesting framework will be effective only if it is subject to strong governance andeffective internal controls to ensure the framework is functioning asintended. Stronggovernanceand effective internal controls help ensure that the framework containscoreelements, from clearly defined stresstesting objectives to recommendedactions.Importantly, strong governance providescritical review of elementsof the stresstesting framework, especially regarding key assumptions, uncertainties, andlimitations.Abanking organization should ensurethat thestresstesting framework isnot isolatedwithin a banking organization‘s risk management function, but is firmly integratedintobusiness lines, capital and asset-liability committees, and other decision makingbodies.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)
  28. 28. 28Along thoselines, theboard of directorsand senior managementshould play keyrolesin ensuring strong governance and controls.The extent and sophistication of a banking organization‘s governance over its stresstesting framework should align with the extent and sophisticationof that framework.Additional details regarding governance and controls of an organization‘s stresstesting framework areoutlined in section VI.IV. StressTesting ApproachesandApplicationsThis section discussessomegeneral typesof stresstesting approaches andapplications.For any type of stresstest, banking organizationsshould indicate thespecific purposeand the focus of the test.Defining the scopeof a given stresstest isalsoimportant, whether it applies at theportfolio, businessline, risk type, or enterprise-wide level, or even just for anindividual exposureor counterparty.Basedon the purposeand scope of the test, different stresstesting techniques aremost useful.Thus, a banking organization should employ several approaches andapplications;these might include scenario analysis, sensitivity analysis,enterprise-wide stresstesting, and reversestresstesting.Consistent with Principle 1, banking organizations should apply thesecommensuratewith their size, complexity, and businessprofile, and may not need to incorporate allof the details describedbelow.Consistent with Principle 3, banking organizations should also recognizethat stresstesting approaches will evolve over time and they should update their practices asneeded.ScenarioAnalysisScenario analysis refersto a type of stresstesting in which a banking organizationapplies historical or hypothetical scenariosto assessthe impact of various eventsandcircumstances, including extremeones.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)
  29. 29. 29Scenarios usually involve somekind of coherent, logical narrativeor ―story‖ asto whycertain eventsand circumstances canoccur and in which combination and order,such asa severe recession, failureof a major counterparty, lossof major clients,natural or man-made disaster, localized economic downturn, disruptionsin fundingor capital markets,or a sudden change in interestratesbrought about by unfavorableinflation developments.Scenario analysis can be applied at various levels of the banking organization, such aswithin individual businesslinesto help identify factorsthat could harm thosebusinesslinesmost.Stressscenariosshould reflect a banking organization‘s unique vulnerabilitiestofactorsthat affect itsexposures, activities, and risks.Forexample,if abanking organization is concentratedin aparticularlineof business,such ascommercial real estateor residential mortgage lending, it would beappropriate to explorethe impact of a downturn in thoseparticular market segments.Similarly, a banking organization with lending concentrations to oil and gascompaniesshould include scenariosrelated to the energysector.Other relevant factorsto be considered in scenario analysis relateto operational,reputational and legal risksto a banking organization, such assignificant eventsoffraud or litigation, or a situation when a banking organization feels compelled toprovide support to an affiliate or provide other types of non-contractual support toavoid reputational damage.Scenarios should be internally consistent and portray realistic outcomesbased onunderlying relationshipsamong variables, and should include only thosemitigatingdevelopmentsthat areconsistent with the scenario.Additionally, a banking organization should consider the best manner to try tocapturecombinationsof stressful eventsand circumstances, including second-orderand ―knock-on‖ effects.Ultimately, a banking organization should select and design multiple scenariosthatarerelevant to itsprofile and make intuitive sense, use enough scenariosto explorethe range of potential outcomes, and ensure that the scenarioscontinue to be timelyand relevant.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)
  30. 30. 30Abanking organization may apply scenario analysis within the context of itsexistingrisk measurement tools (e.g., the impact of a severedeclinein market prices on abanking organization‘s value-at-risk (VaR) measure) or useit asan alternative,supplemental measure.Forinstance, abanking organization mayusescenario analysis to measuretheimpactof a severe financial market disturbance and comparethoseresultsto what isproduced by its VaR or other measures.This type of scenario analysis should account for known shortcomingsof other riskmeasurementpractices.For example, market risk VaR models generally assumeliquid marketswith known prices.Scenario analysis could shed light on the effects of a breakdown in liquidity and ofvaluation difficulties.Oneof the keychallengeswith scenario analysisis to translatea scenariointobalancesheet impact, changesin risk measures, potential losses, or other measuresofadversefinancial impact, which would vary depending on the test design and the type ofscenario used.For someaspectsof scenario analysis, banking organizationsmayuseeconometric orsimilartypesof analysis to estimatea relationship betweensomeunderlying factorsordrivers and risk estimatesor lossprojectionsbased on a given data set, and thenextrapolateto seethe impact of more severeinputs.Careshould be taken not to make assumptionsthat relationshipsfrom benign ormildly adversetimeswill hold during more severe timesor that estimatingsuchrelationshipsis relativelystraightforward.For example, linear relationships betweenrisk drivers and lossesmaybecomenonlinear during timesof stress.In addition, organizations should recognize that therecan be multiple permutationsof outcomesfrom just a few key risk drivers.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)
  31. 31. 31Sensitivity AnalysisSensitivityanalysis refersto a banking organization‘s assessment of itsexposures,activities, and risks when certain variables, parameters,and inputsare―stressed‖ or―shocked.‖Akey goal of sensitivity analysis is to test the impact of assumptionson outcomes.Generally, sensitivity analysis differsfrom scenario analysis in that it involveschanging variables, parameters,or inputs without an explicit underlying reasonornarrative, in order to explorewhat occursunder a range of inputsand at extremeorhighly adverselevels.In this type of analysis a banking organization may realize, for example, that a givenrelationship is much more difficult to estimate at extremelevels.Abanking organization may apply sensitivity analysis at variouslevelsof aggregationto estimate the impact from a change in one or more key variables.The resultsmayhelp abanking organization better understand therangeof outcomesfrom some of its models, such asdeveloping a distribution of output based on avarietyof extremeinputs.For example, a banking organization may chooseto calculatea range of changesto astructured security‘s overall value using a range of different assumptions about theperformanceand linkageof underlying cash flows.Sensitivityanalysis should be conducted periodically due to potential changesin abanking organization‘s exposures, activities, operating environment, or therelationship of variables to one another.Sensitivityanalysis can also help to assessa combined impact on a bankingorganization of several variables, parameters,factors, or drivers.For example, a banking organization could better understand the impact on itscreditlossesfrom a combined increase in default ratesand a decrease in collateral values.Abanking organization could also explore the impact of highly adversecapitalizationrates, declines in net operating income, and reductionsin collateral when evaluatingitsrisks from commercial real estateexposures.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)
  32. 32. 32Sensitivityanalysis canbe especially useful becauseit is not necessarily accompaniedby a particular narrative or scenario; that is, sensitivity analysis can provide bankingorganizationsmoreflexibility to explore the impact of potential stressesthat theymaynot be able to capturein designed scenarios.Furthermore, banking organizationsmay decide to conduct sensitivity analysis oftheir scenarios, i.e., choosing different levels or paths of variables to understand thesensitivities of choices made during scenario design.For instance, banking organizationsmay decide to apply a few different interest-ratepathsfor a given scenario.Enterprise-Wide StressTestingEnterprise-widestresstestingisanapplication ofstresstestingthatinvolves assessingthe impact of certain specified scenarioson the banking organization asa whole,particularly with regard to capital and liquidity.Asis the casewith scenario analysis moregenerally, enterprise wide stresstestinginvolves robust scenario design and effective translation of scenarios into measuresofimpact.Enterprise-widestresstests canhelp abanking organization in itseffortsto assesstheimpact of its full set of risks under adverse eventsand circumstances, but should besupplementedwith other stresstests and other risk measurementtools given inherentlimitations in capturing all risksand all adverseoutcomesin one test.Scenario design for enterprise-wide stresstesting involvesdeveloping scenariosthataffect the banking organization asa whole that stem from macroeconomic,market-wide, and/or firm-specificevents.Thesescenariosshould incorporate the potential simultaneousoccurrenceof bothfirm-specific and macroeconomic and market-wide events, considering system-wideinteractionsand feedback effects.For example, price shocks may lead to significant portfolio losses, rising fundinggaps, a ratings downgrade, and diminished accessto funding.In general, it is a good practiceto consult with a large set of individualswithin thebanking organization – in variousbusiness lines, researchand risk areas– to gain awide perspectiveon how enterprisewide scenarios should be designed and to ensureBasel iii ComplianceProfessionalsAssociation (BiiiCPA)
  33. 33. 33that the scenarioscapturethe relevant aspectsof the banking organization‘s businessand risks.Banking organizations should alsoconduct scenariosof varying severityto gauge therelative impact.At least somescenarios should be of sufficient severityto challengethe viability of thebanking organization, and should include instantaneousmarket shocksand stressfulperiodsof extended duration (e.g., not just a one or two-quarter shock after whichconditionsreturn to normal).Selectionof scenario variables is important for enterprise-wide tests, because thesevariables generally serveasthe link betweenthe overall narrative of the scenario andtangible impact on the banking organization asa whole.For instance, in aiming to capture the combined impact of a severe recession and afinancial marketdownturn, abanking organizationmaychoosea set of variables suchaschangesin grossdomesticproduct(GDP), unemployment rate,interestrates,stockmarket levels, or home price levels.However, particularly when assessing the impact on the whole banking organization,usingalargenumber of variables can makea test morecumbersomeand complicated– soa banking organization mayalsobenefit from simpler scenarios or from thosewith fewervariables.Banking organizations should balance the comprehensivenessof contributingvariables and tractability of the exercise.Aswith scenario analysis generally, translating scenariosinto tangible effectson thebanking organization asa whole presentscertain challenges.Abanking organization should identify appropriate and meaningful mechanismsfortranslating scenariosinto relevant internal risk parametersthat provide a firm-wideview of risks and understanding of how these risksaretranslated into lossestimates.Not all businessareasare equally affected by a given scenario, and problemsin onebusinessareacan have effects on other units.However, for anenterprise-widetest, assumptionsacrossbusinesslinesand riskareasshould remain constant for the chosen scenario, since the objective is to seehow thebanking organization asa whole will be affectedby a common scenario.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)
  34. 34. 34Reverse StressTestingReversestresstesting is a tool that allows a banking organization to assumea knownadverseoutcome, suchassuffering a credit lossthat breachesregulatorycapital ratiosor suffering severeliquidity constraintsthat render it unable to meet its obligations,and then deduce the typesof eventsthat could lead to such an outcome.This type of stresstesting may help a banking organization to consider scenariosbeyond itsnormal businessexpectationsand seetheimpactof severesystemic effectson the banking organization.It also allows a banking organization to challenge common assumptionsabout itsperformanceand expected mitigation strategies.Reversestresstesting helps to explore so-called ―break the bank‖ situations, allowinga banking organization to set aside the issue of estimating the likelihood of severeeventsand to focus more on what kinds of eventscould threaten the viability of thebanking organization.This type of stress testing also helps a banking organization evaluate the combinedeffect of several types of extreme events and circumstances that might threaten thesurvival of the banking organization, even if in isolation each of the effects might bemanageable.For instance, reversestresstesting may help a banking organization recognize that acertain level of unemployment would have a severe impact on credit losses,that amarket disturbance could createadditional lossesand result in rising funding costs,and that a firm-specificcaseof fraud would causeeven furtherlossesand reputationalimpact that could threaten a banking organization‘s viability.In somecases, reversestresstestscould reveal to a banking organization that―breaking the bank‖ isnot asremote an outcome asoriginally thought.Given the numerouspotential threats to a banking organization‘s viability, theorganization should ensurethat it focusesfirston thosescenariosthat havethelargestfirm-wide impact, such asinsolvency or illiquidity, but also on thosethat seemmostimminent given the current environment.Focusing on the most prominent vulnerabilitieshelpsa banking organizationprioritize its choice of scenariosfor reversestresstesting.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)
  35. 35. 35However, a banking organization should alsoconsider a widerrange of possiblescenarios that could jeopardize the viability of the banking organization, exploringwhat could representpotential blind spots.Reversestresstesting can highlight previously unacknowledgedsourcesof risk thatcould be mitigated through enhanced risk management.V. StressTesting for Assessing theAdequacy of Capital andLiquidityThere are many usesof stresstesting within banking organizations.Prominent amongthesearestresstestsdesignedto assesstheadequacyof capital andliquidity.Given the importance of capital and liquidity to a banking organization‘sviability,stresstesting should be applied in thesetwo areasin particular, including anevaluation of theinteractionbetweencapital and liquidity and thepotential for both tobecomeimpaired at the same time.Depletionsand shortagesof capital or liquidity can causea banking organization tono longer perform effectively asa financial intermediary, be viewed by itscounterpartiesasno longer viable, becomeinsolvent, or diminish itscapacity to meetlegal and financial obligations.Abanking organization‘scapital and liquidity stresstesting should consider howlosses, earnings,cashflows, capital, and liquidity wouldbeaffectedin anenvironmentin whichmultiple risksmanifest themselvesatthesametime,for example,anincreasein credit lossesduring an adverseinterest-rate environment.Additionally, banking organizationsshould recognize that at the end of the timehorizon consideredby a given stresstest, they may still have substantial residual risksor problem exposuresthat may continue to pressurecapital and liquidity resources.Stresstesting for capital and liquidity adequacy should be conducted in coordinationwith a banking organization‘s overall strategyand annual planning cycles.Resultsshould be refreshedin the event of major strategic decisions, or otherdecisions that can materially impact capital or liquidity.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)
  36. 36. 36Banking organizationsshould conduct stresstesting for capital and liquidityadequacyperiodically.Capital StressTestingCapital stresstesting resultscan serveasa useful tool to support a bankingorganization‘s capital planning and corporate governance.They may help a banking organization better understand itsvulnerabilities andevaluatethe impact of adverse outcomeson itscapital position and ensurethat thebanking organization holdsadequate capital given itsbusiness model, including thecomplexity of its activitiesand itsrisk profile.Capital stresstesting complementsa banking organization‘s regulatory capitalanalysis by providing a forward-looking assessmentof capital adequacy, usually witha forecasthorizon of at least two years(with the recognition that the effects of certainstressconditionscould extend beyond two yearsfor some stresstests), andhighlighting the potential adverse effects on capital levels and ratiosfrom risks notfully captured in regulatory capital requirements.It should also be used to help a banking organization assessthe quality andcomposition of capital and itsability to absorb losses.Stresstesting can aid capital contingency planning by helping management identifyexposuresor risksin advancethat would needto be reducedand actionsthat could betaken to bolster capital levels or otherwisemaintain capital adequacy, aswell asactionsthat in timesof stressmight not be possible – such asraising capital.Capital stresstesting should include exercisesthat analyze the potential for changesin earnings, losses, reserves, and other potential effects on capital under a variety ofstressful circumstances.Suchtesting should alsocaptureany potential change in risk-weighted assets, theability of capital to absorb losses, and any resulting impact on the bankingorganization‘s capital ratios.It should include all relevant risk typesand other factorsthat have a potential to affectcapital adequacy, whetherdirectly or indirectly, including firm-specificones.A banking organization should also explore the potential for possible balance sheetexpansion to put pressure on capital ratios and consider risk mitigation and capitalpreservationoptions, other than simply shrinking the balance sheet.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)
  37. 37. 37Capital stresstesting should assessthepotential impact of a banking organization‘smaterial subsidiaries suffering capital problemson their own – such asbeing unableto meet local country capital requirements– even if the consolidated bankingorganization is not encountering problems.Wherematerial relative to the banking organizations capital, counterparty exposuresshould alsobe included in capital stresstesting.Enterprise-widestresstesting, asdescribedin sectionIV, should beanintegral part ofa banking organization‘scapital stresstesting.Suchenterprise-wide testing should include proforma estimatesof not only potentiallossesand resourcesavailable toabsorb losses, but also potential planned capitalactions(such asdividends or sharerepurchases)that would affect the bankingorganization‘s capital position, including regulatoryand other capital ratios.There should alsobe consideration of the impact on the banking organization‘sallowancefor loan and leaselossesand other relevant financial metrics.Even with very effective enterprise-wide tests, banking organizationsshould usecapital stresstesting in conjunction with other internal approaches (in addition toregulatorymeasures) for assessing capital adequacy, such asthosethat rely primarilyon statistical estimatesof risk or lossestimates based on historical data.Liquidity stresstestingAbanking organization should alsoconduct stresstesting for liquidity adequacy.Through such stresstesting a banking organization can work to identifyvulnerabilitiesrelated to liquidity adequacy in light of both firm-specificandmarket-wide stressevents and circumstances.Effective stresstesting helpsa banking organization identify and quantify the depth,source, and degreeof potential liquidity and funding strain and to analyze possibleimpactson itscash flows, liquidity position, profitability, and other aspectsof itsfinancial condition over varioustime horizons.For example, stresstesting can be used to explorepotential funding shortfalls,shortagesin liquid assets, the inability to issue debt, exposure to possible depositoutflows, volatility in short-term brokered deposits, sensitivity of funding to a ratingsdowngrade, and the impact of reducedcollateral values on borrowing capacity at theFederal Home Loan Banks, the Federal Reservediscount window, or other securedBasel iii ComplianceProfessionalsAssociation (BiiiCPA)
  38. 38. 38wholesale funding sources.Liquidity stresstesting should explore the potential impact of adverse developmentsthat mayaffect market and asset liquidity, including the freezing up of credit andfunding markets, and the corresponding impact on the banking organization.Suchtestscan also help identify the conditions under which balance sheets mightexpand, thus creatingadditional funding needs (e.g., through accelerateddrawdownson unfunded commitments).Thesetests alsohelp determine whether the banking organization has a sufficientliquidity buffer to meet varioustypesof future liquidity demandsunder stressfulconditions.In this regard, liquidity stresstesting should be an integral part of the developmentand maintenanceof a banking organization‘s contingency funding planning.Liquidity stresstesting should include enterprise wide tests as discussed in section IV,but should also be applied, as appropriate, at lower levels of the banking organization,and in particular should account for regulatoryor supervisory restrictionsoninter-affiliate funding and asset transfers.Aswith capital stresstesting, banking organizationsmay need to conduct liquiditystresstests at both the consolidated and subsidiary level.In undertaking enterprise-wide liquidity tests banking organizationsshould makerealisticassumptionsasto the implicationsof liquidity stressesin one part of thebanking organization on other parts.An effective stresstesting framework should explorethe potential for capital andliquidity problemsto ariseat the sametime or exacerbate oneanother.For example, a banking organization in a stressedliquidity position is often requiredto takeactionsthat have a negative direct or indirect capital impact (e.g., sellingassetsat a loss or incurring funding costsat above market ratesto meet fundingneeds).Abanking organization‘sliquidity stressanalysis should explore situationsin whichthe banking organization maybe operating with a capital position that exceedsregulatoryminimums, but is nonethelessviewed within thefinancial marketsor by itscounterpartiesasbeing of questionable viability.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)
  39. 39. 39Assessingthepotential interactionofcapital and liquiditycanbechallengingand maynot be possible within a single stresstest, soorganizationsshould explore severalavenuesto assessthat interaction.Aswith other applicationsof stresstesting, for itscapital and liquidity stresstests, it isbeneficial for a banking organization to articulate clearly itsobjectives for apost-stressoutcome, for instance to remain a viable financial market participant thatis able to meet itsexisting and prospective obligations and commitments.In such cases,banking organizationswould have to consider which measuresoffinancial condition would need to be met on a post-stressbasis to securetheconfidenceof counterpartiesand market participants.VI. Governance and ControlsAsnoted under Principle 5, a banking organization‘s stresstesting framework will beeffective only if it is subject to strong governance and controls to ensure theframework is functioning asintended.The extent and sophistication of a banking organization‘s governanceover its stresstesting framework should align with the extent and sophistication ofthat framework.Governanceover a banking organization‘s stresstesting framework restswith thebanking organization‘s board of directorsand senior management.Aspart of their overall responsibilities, a banking organization‘s board and seniormanagementshould establish acomprehensive, integratedand effective stresstestingframework that fits into the broader risk management of the banking organization.While the board is ultimately responsible for ensuring that the banking organizationhas an effective stresstesting framework, senior management generally hasresponsibilityfor implementing that framework.Senior management duties should include establishing adequate policiesandproceduresand ensuring compliance with those policies and procedures, assigningcompetent staff, overseeing stresstest development and implementation, evaluatingstresstest results, reviewing any findings relatedto the functioning of stresstestprocesses,and taking prompt remedial action wherenecessary.Senior management, directly and through relevant committees, also should beBasel iii ComplianceProfessionalsAssociation (BiiiCPA)
  40. 40. 40responsible for regularly reporting to the board on stresstesting developments(including the processto design tests and develop scenarios) and on stresstestingresults(including from individual tests, wherematerial), aswell ason compliancewith stresstesting policy.Board members should actively evaluate and discuss this information, ensuring thatthe stress testing framework is in line with the banking organization‘s risk appetite,overall strategy and business plans, and contingency plans, directing changes whereappropriate.Abanking organization should have writtenpolicies, approved and annually reviewedby the board, that direct and govern the implementation of the stresstestingframework in a comprehensivemanner.Policies, along with proceduresto implement them, should:Describe the overall purposeof stresstesting activities;Articulate consistent and sufficiently rigorousstresstesting practices acrosstheentirebanking organization;Indicate stresstesting roles and responsibilities, including controls over externalresourcesusedfor any part of stresstesting (such asvendorsand data providers);Describe the frequencyand priority with which stresstesting activitiesshould beconducted;Indicate how stresstest resultsareused, by whom, and outline instancesin whichremedial actionsshould be taken; andBereviewedand updated asnecessaryto ensurethat stresstesting practices remainappropriate and keepup to date with changesin market conditions, bankingorganization productsand strategies, banking organization exposuresand activities,the banking organization‘s established risk appetite, and industry stresstestingpractices.Astresstesting framework should incorporate validation or other type of independentreview to ensure the integrity of stresstesting processesand results, consistent withexistingsupervisory expectations.If a banking organization engagesa third party vendor to support some or all of itsstresstesting activities, thereshould be appropriate controls in place to ensure thatBasel iii ComplianceProfessionalsAssociation (BiiiCPA)
  41. 41. 41thoseexternally developed systemsand processesaresound, applied correctly, andappropriate for the banking organization‘s risks, activities, and exposures.Additionally, senior management should be mindful of any potential inconsistencies,contradictions, or gapsamong itsstresstests and assesswhat actions should be takenasa result.Internal audit should alsoprovide independent evaluation of the ongoingperformance, integrity, and reliabilityof the stresstesting framework.Abanking organization should ensure that itsstresstests are documentedappropriately, including a description of the typesof stresstests and methodologiesused, key assumptions, results, and suggestedactions.Senior management, in consultation with the board, should review stresstestingactivities and resultswith an appropriately critical eye and ensure that there isobjective review of all stresstesting processes.The resultsof stresstesting analysesshould facilitate decision-making by the boardand senior management.Stresstesting resultsshould be used to inform the board about alignment of thebanking organization‘s risk profile with the board‘s chosen risk appetite, aswell asinform operating and strategic decisions.Stresstesting resultsshould be considered directly by the board and seniormanagementfor decisionsrelatingto capital andliquidityadequacy, including capitalcontingency plans and contingency funding plans.Senior management, in consultation with the board, should ensure that the stresstesting framework includesa sufficient rangeof stresstesting activities applied at theappropriatelevels of thebanking organization (i.e., not just oneenterprise-widestresstest).Sound governance also includes using stresstesting to consider the effectivenessof abanking organization‘s risk mitigation techniquesfor variousrisk types over theirrespective time horizons, such asto explore what could occur if expected mitigationtechniques break down during stressful periods.VII. ConclusionAbanking organization should usethe principleslaid out in this guidance to develop,Basel iii ComplianceProfessionalsAssociation (BiiiCPA)
  42. 42. 42implement, and maintain an effective stresstesting framework.Sucha framework should be adequately tailored to the banking organization‘s size,complexity, risks, exposures, and activities.Akey purposeof stresstesting is to explore varioustypes of possible outcomes,including rareand extremeeventsand circumstances, assesstheir impact on thebanking organization, and then evaluate the boundaries up to which the bankingorganization plansto be able to withstand such outcomes.Stresstesting maybe particularly valuable during benign periodswhen othermeasuresmaynot indicate emerging risks.While stresstesting can provide valuable information regarding potential futureoutcomes, similar to any other risk management tool it haslimitations and cannotprovide absolutecertainty regarding the implicationsof assumedeventsand impacts.Furthermore, management should ensure that stress testing activities are notconstrained to reflect past experiences, but instead consider a broad range ofpossibilities.Nosingle stresstest can accuratelyestimate the impact of all stressful eventsandcircumstances;therefore, a banking organization should understand and account forstresstesting limitationsand uncertainties, and use stresstests in combination withother risk management tools to make informed risk management and businessdecisions.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)
  43. 43. 43Guidelines on Stressed Value-At-Risk (Stressed VaR) and on theIncremental Default and Migration Risk Charge (IRC)16May 2012The EBApublished today twosets of Guidelines on Stressed Value-At-Risk (StressedVaR) and on the Incremental Default and Migration Risk Charge(IRC) modellingapproaches employed by credit institutionsusing the Internal Model Approach(IMA).TheseGuidelines are seen asan important meansof addressing weaknessesin theregulatorycapital framework and in the risk management of financial institutions.Their objective is to contribute to a level playing field and to enhanceconvergence ofsupervisory practices acrossthe EU.National competent authorities areexpected to implement the provisions set out inthe Guidelines within six monthsafter their publication.After that date, the competent authorities must ensure that institutions comply withthe Guidelines effectively.Guidelines on Stressed Value-At-Risk (Stressed VaR)TheseGuidelines include provisions on StressedVaR modelling by credit institutionsusing the Internal Model Approach for the calculationof the required capital formarket risk in the trading book.The main provisions of the Guidelines relateto:Basel iii ComplianceProfessionalsAssociation (BiiiCPA)
  44. 44. 44-The identification and the review of the stressedperiod;- The Stressed VaR methodology;- The Usetest.Guidelines on the Incremental Default and Migration RiskCharge (IRC)TheseGuidelines include provisions on the IRC modelling approachesemployed bycredit institutionsusing the Internal Model Approach (‗IMA‘) for the calculation ofthe required capital for specific interest risk in the trading book.The incremental risk charge is intended to complement additional standardsbeingapplied to the value-at-risk (VaR) modelling framework in the trading book.The main provisions of the Guidelines relateto:- The scope of application; Individual modelling of all aspectsof the IRC approach- The interdependencebetweendefault and migration events;-The profit and losses(P&L) valuation including how ratingschangesimpact onmarket prices and on the computation of P&L;- The liquidity horizons;- The validation and use test for IRC models.Notes1) According to the amendmentsof the Capital RequirementsDirective by Directive2010/76/EU, entered into force on 31December 2011, the EBAis tasked withmonitoring the rangeof practices in theareaof StressedValue-at-Risk (StressedVaR)and Incremental Default and Migration Risk Charge (IRC) in the trading book.The EBAshall draw up guidelines in order to ensureconvergence of supervisorypractices.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)
  45. 45. 452) In accordancewithArticle 16(3) of the EBARegulation, Guidelines set out theEBA‘sview of appropriate supervisory practiceswithin the European System ofFinancial Supervision or of how Union law should be applied in a particular area.Competent authoritiesand financial market participantsmust make every effort tocomply with the guidelines.Beforethe deadlineindicated in the Guidelines, i.e 6 months from the date ofpublication, Competent authorities must notify the EBAasto whether theycomply orintendto comply with theseguidelines,orotherwisewithreasonsfor non-compliance.The notificationsshall be published on the EBAwebsite.EBAGuidelineson Stressed ValueAt Risk (Stressed VaR)16.05.2012I. Executive SummaryThe amendmentsto the Capital RequirementsDirective1 by Directive 2010/76/EU(CRD III) relate, among others, to StressedValue-at-Risk (Stressed VaR) in thetrading book.According to theseamendments, the predecessorof the EBA, the Committee ofEuropean Banking Supervisors(CEBS) is tasked with monitoring the range ofpractices in this areaand drawing up guidelinesin order to ensureconvergence ofsupervisory practices.The amendmentsto the Capital RequirementsDirective by Directive 2010/76/EU(CRD III) entered into force on 31December2011.Providing guidance on Stressed VaR modelling by credit institutions using theInternal ModelApproach (‗IMA‘) for the calculation of therequiredcapital for marketrisk in the trading book, is seenasan important meansof addressing weaknessesinthe regulatorycapital framework and in the risk management of financial institutionsthat contributed to the turmoil in global financial markets.It isalsoexpected to reducereliance on cyclical VaR-basedcapital estimatesaswellasto contribute to the development of a morerobust financial system.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)
  46. 46. 46The first chapter, on ‗Identification and validation of the stressedperiod‘, elaborateson the value-at-risk model inputs calibratedto historical data from a continuous12-month period of significant financial stressrelevant to an institution‘s portfolioanddeals withi)The length of the stressedperiod,ii) The number of stressed periodsto usefor calibration,iii) The approach to identify the appropriate historical period andiv)The required documentation to support the approach used to identify the stressedperiod.The second chapter, on ‗Review of the stressed period‘ provides guidance on thefrequencyand monitoring of a stressed period.The third chapter on ‗StressedVaR methodology‘ deals withi) Consistencyissuesbetweenthe VaR and StressedVaR methodologies andii) The useand validation of proxies in Stressed VaR modelling.The fourth and final chapter, entitled ‗Use tests‘specifies use test requirements.The Guidelines on Stressed VaR are expected to contribute to a level playing fieldamong institutionsand to enhanceconvergence of supervisory practices among thecompetent authoritiesacrossthe EU.It isexpected that the national competent authorities around the EU will implementthe Guidelines by incorporating them within their supervisory procedures within sixmonthsafter publication of the final guidelines.After that date, the competent authorities must ensure that institutions comply withthe Guidelines effectively.II. Background and RationaleThe CRD III trading book amendments, including the requirement of Stressed Valueat Risk (VaR) modelling for the calculation of the regulatory capital for market risk inthe trading book, arethe result of widespread international (G20, Basel, FSF)Basel iii ComplianceProfessionalsAssociation (BiiiCPA)
  47. 47. 47recognition in 2008that further regulatoryreform wasneeded to addressweaknessesin the current regulatory capital framework and in the risk management of financialinstitutions that contributed to the turmoil in global financial markets.In January 2009, the Basel Committee on Banking Supervision (BCBS) proposedsupplementing the current VaR-based trading book framework with, among othermeasures, an incremental risk capital charge (IRC), which includesdefault risk aswell asmigration risk for unsecuritised credit productsand a stressed value-at-riskrequirement.Asobserved lossesin banks trading books during the financial crisis have beensignificantly higher than the minimum capital requirementsunder the Pillar 1marketrisk rules, the BCBSproposed to enhancethe framework through requiring banks tocalculate, in addition to the current VaR, a stressed VaR taking into account aone-year observation period relating to significant losses.The additional stressed VaR requirement is expected to help reduce thepro-cyclicality of the minimum capital requirementsfor market risk.In the processof refining capital requirementsfor market risk, the BCBSconducted aquantitative impact study.In thesummerof 2009, the Trading Book Group (TBG) investigated the impactof theprovisionsof the ‗Revisionsto the Basel II market risk framework‘ and of the‗Guidelines for computing capital for incremental risk in the trading book‘consultation paperspublished in January 2009, focusing (generally) on biginternationally-active banks with extensivetrading activities.The amendmentsto the Capital RequirementsDirective by Directive 2010/76/EU(CRD III) relatingto StressedVaRin thetradingbook areadirecttransposition of theproposalsfrom the BCBSin the EU context.The European BankingAuthority is requestedto monitor the rangeof practices inthis areaand to provide guidelines on Stressed VaR models.The objectives of these Guidelines on StressedVaR are:I. To achieve a common understanding among the competent authoritiesacrosstheEU on StressedVaR modelling in order to enhanceconvergence of supervisorypractices;Basel iii ComplianceProfessionalsAssociation (BiiiCPA)