The Reserve Bank of India in its communication in 2007 had stated that in the present liberalised environment, banks need to have a robust and sound stress testing process for assessment of capital adequacy. The stress testing involves identifying possible events, future economic conditions that could unfavourably impact bank’s credit exposures and making an assessment of the ability of banks to withstand the loss arising out of such events. There is also a need for carrying out stress tests on the asset portfolio incorporating various scenarios, like economic downturns, industrial downturns, market risk events and sudden shifts in liquidity conditions.
Some of the steps involved could be :
* The banks are required to project their credit losses and revenues for the current year and next, including the level of reserves that they would need at the end of next year to cover expected losses in the third year.
* Projections are to be made based on two different economic scenarios. A "baseline scenario" that reflects the current economic expectations and a “more adverse scenario,”* Banks are required to provide supporting documentation, including information on projected income and expenses. to help authorities to decide whether the bank’s loss estimates were appropriate – and how the bank would absorb those losses.
* Each bank’s projected losses, revenue and changes in reserve are combined to evaluate the amount and quality of capital the bank would have at the end of next year. If a bank is found to have less capital than projected by the stress test under the adverse scenario, it would have to augment its capital, or create a “capital buffer” that it could use to offset losses if the economy turns out to take an even bigger turn for the worse than expected.
Some of the steps involved could be :
* The banks are required to project their credit losses and revenues for the current year and next, including the level of reserves that they would need at the end of next year to cover expected losses in the third year.
* Projections are to be made based on two different economic scenarios. A "baseline scenario" that reflects the current economic expectations and a “more adverse scenario,”* Banks are required to provide supporting documentation, including information on projected income and expenses. to help authorities to decide whether the bank’s loss estimates were appropriate – and how the bank would absorb those losses.
* Each bank’s projected losses, revenue and changes in reserve are combined to evaluate the amount and quality of capital the bank would have at the end of next year. If a bank is found to have less capital than projected by the stress test under the adverse scenario, it would have to augment its capital, or create a “capital buffer” that it could use to offset losses if the economy turns out to take an even bigger turn for the worse than expected.
Contributed by:
Prof. Bikramjit Sen
(Globsyn Business School)
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