The Monetary Board (MB) approved the Guidelines on the Conduct of Stress Testing Exercises, which provide the overarching governance standards and risk management expectations on stress testing practices in the banking industry.
Stress testing is defined as a tool to evaluate the potential effects of specified changes in risk factors on a bank’s financial position under a severe but plausible scenario. In this respect, banks are expected to develop sound assumptions generally depicting events or scenarios that may result in significant losses and to assess the impact of these scenarios on the bank’s performance or capital and liquidity positions. For instance, banks may assume 50 percent default in the loan portfolio and assess its impact on capital adequacy ratio (CAR) and level of available funds.
The BSP is issuing the stress testing guidelines as part of its continuing initiatives to further strengthen risk governance and contribute to the sustained safety and soundness of the industry. Stress testing allows banks to prepare for events with severe financial impact. In particular, based on the results of stress testing, banks may adopt proactive measures such as the implementation of capital build up initiatives or enhancement of risk management practices all aimed at improving their resilience in times of actual crisis.
Related to this, the issuance provides that the board of directors should consider the results of stress testing exercises in capital and liquidity planning, in setting risk appetite, and in planning for business continuity management, and, in the case of domestic systemically important banks (DSIBS), in developing recovery plans. These expectations are consistent with the earlier issued guidelines on corporate governance under Circular No. 969.
Banks are expected to employ a combination of different approaches for stress testing. Methodologies may range from simple sensitivity analysis to the more complex tools, such as scenario analysis and reverse stress testing. Following the principle of proportionality, simplified requirements are set out for stand-alone thrift, rural and cooperative banks.
The fundamental requirements for system and model capabilities for the conduct of effective stress testing exercises have been laid out in Circular No. 971 on risk governance. Specifically, the principles of accuracy and integrity; completeness; timeliness; and adaptability, are the same underpinnings of robust stress testing exercises.
The approved guidelines are applicable to all types of banks on solo and consolidated bases. Banks that are part of group structures shall conduct stress testing exercises on a consolidated basis or at the parent bank’s level, covering all institutions considered as material entities in the banking group. The Bangko Sentral is giving banks a period of two (2) years from the effectivity date of the issuance to gradually progress from their existing stress testing practices to fully meet the expectations in the Circular.