[UNCOMPLETE] July 10, 2009

Fundamental Stress Testing Procedure for Private

commercial Bank in Bangladesh
***Tamzidul Islam Chowdhury

Introduction:

The global financial crisis has its origins in the U.S. subprime mortgage crisis of August 2007. It
seemed initially that it would only affect developed countries, but the so-called “decoupling
phenomenon,” which predicted that developing countries would remain unaffected, has not
occurred. Instead the crisis has become a global phenomenon and global growth projections have
fallen, stock markets have plummeted, and currencies have lost value against the dollar.
However, this crisis has several downside risks for the Bangladesh economy. Bangladesh is not
yet affected barely but the impact on the Bangladesh economy will depend on the nature, scope,
severity and duration of the crisis. Although the economy of Bangladesh has become
increasingly integrated with the global economy in recent years but the country’s financial sector
is not as globally integrated as its neighbor’s countries. Therefore, countries financial markets
have not so far to feel any direct impacts. The banking sector is mostly separated from
international financial markets and does not have sophisticated products. Therefore the risks
remain mainly in the area of export earning, remittances and foreign aid, which may perhaps,
creates macroeconomic shocks in economy. Under these circumstances, fitness of banks is
important issues for continued existence in crisis with a sound financial system. Banks might
lose their deposits by falling remittances and banks existing non-performing loan would become
double, if a major shock creates in exports sector. In this context, stress test practice is required
for banks to verify their risks and to cope with the crisis eventually. Usually, Stress testing
represents a risk management tool used to evaluate the potential impact on a bank (or a group of
entities) of a specific event and / or movement in a set of financial or macro variables. It is
important to note that stress testing has to be regarded as a complementary tool to major risk
management instruments such as value-at-risk analysis. The stress tests permit a forward-
looking analysis and a uniform approach to identifying potential risks, generated by exceptional
but plausible shocks to the banking system as a whole. Banks perform stress tests for their
internal needs in order to identify reaction of sectors to extreme events; assess the sensitivity of
credit factors and approaches to extreme events in order to ensure appropriateness; identify
“hidden” correlations within portfolio; support portfolio allocations decisions and strategy
beyond normal current conditions; evaluate potential capital requirements under possible future
credit environments; and identify benchmarks to create some awareness of the current market
situation. Bangladesh bank is already taken some practices but not sufficient for impending
crisis. Individual bank should do this immediately to identify where risk are concentrate and
understand the impact on bank balance sheet, if biggest customers default. The paper aimed at
laying down the main elements of the banks’ stress testing methodologies conveniently, as
captured by relevant international guidance.
 [UNCOMPLETE] July 10, 2009

Literature review:

The International Monetary Fund (IMF) and the World Bank (WB) have initiated the Financial
Sector Assessment Program (FSAP), which strives to assess strengths and vulnerabilities in their
member countries’ financial systems. The assessments under this program have so far covered
more than 50 jurisdictions and provided various recommendations for improvement in the
financial system framework (many of the assessments are available on the IMF and WB
websites). Stress testing was from the beginning a key element of the assessment of financial
sector stability.
Stress testing in the FSAP has evolved. Most FSAP missions to date have included single-factor
sensitivity analysis based on historical extreme values, although an increasing number have also
applied scenario analyses, using multiple techniques to determine the size of shocks. While
almost all stress tests relied on data provided by the authorities, the involvement of the
authorities in the recent FSAP missions has gone beyond providing data, as they have also been
actively involved in designing and implementing stress tests in the recent FSAP missions.
Moreover, recent FSAP missions to industrialized countries have aimed to improve the
effectiveness of stress tests through the use of macroeconomic models, the analysis of contagion
resulting from interbank exposures, and the involvement of major financial institutions in the
stress testing exercise (IMF and the World Bank, 2003).

The availability and quality of data impose major constraints on the nature of the stress tests that
can be performed. Data limitations have come in three forms: (i) basic data availability,
especially in countries where information on key exposures may not be available; (ii) an inability
to isolate the desired exposures in a financial institution, especially in the case of complex
financial institutions or institutions which are active in the derivative markets; and (iii)
confidentiality issues—limitations on what the authorities are legally able to share with the
mission.

The experience of the FSAP to date suggests that the types of stress tests need to be tailored to
country-specific circumstances, the complexity of the financial system, and data availability. In
industrialized countries, the analysis can be strengthened by using macroeconomic models (to
help calibrate the scenarios and arrive at a consistent set of assumptions for the tests), the
analysis of interbank contagion, and the involvement of major banks in the stress testing exercise
(IMF and World Bank, 2003).

The experience also suggests that stress tests can have a number of benefits. In particular, they
can help define the amount and nature of the data required for ongoing monitoring of financial
stability, thereby playing an important role of “capacity building.” They can also provide an
independent verification of potential sources of vulnerability and broaden the understanding of
linkages in the financial system (IMF and World Bank, 2003). Several central banks have started
conducting a regular stress testing exercise following the FSAP, some central banks have
increased regulatory attention to stress tests done by commercial banks, and some central banks
have asked for follow-up technical assistance with establishing a framework for conducting
stress tests on a regular basis.
 [UNCOMPLETE] July 10, 2009

Financial soundness indicators and risk analysis for banks:

Risk assessment analysis for banks will be based on financial soundness indicator (FSI). FSIs
monitoring banks return on equity and return on assets indicate the extent to which earnings are
available to absorb losses before capital is impacted. The various measures used in this regards
are ROA, ROE, interest margin to gross income, and liquid assets to total assets.

In using capital ratios to assess financial strength for banks, attention needs to be paid to the
“quality” of the capital. The reason is that the capacity of capital to absorb losses in the event of
insolvency differs for different types of capital. Attention also needs to be paid to the definition,
consolidation rules and valuation approaches used in reported capital measures, since they can
differ across countries. Now we discuss about the key functions of FSIs in terms of banks stress
test. First of all, FSIs of asset quality monitor the loan quality and exposure concentrations of
banks’ asset portfolios. Loan quality is measured by the ratio of NPLs to total loans. FSIs of the
sectoral and geographic distribution of loans to total loans monitor vulnerabilities arising from
concentrated lending exposures to particular sectors or countries. On the other hand, FSIs of
sensitivity to market risk monitor the vulnerability of the financial sector to exchange rate,
interest rate and equity market risk. Secondly, The FSIs of the duration of assets and liabilities
are intended to measure interest rate risk associated with the assets and liabilities, respectively.
The measure of loss from market risk stress tests could in principle is used as a soundness
indicator along with, or even in place of, market risk FSIs. As a final point, FSIs of banking
sector liquidity monitor liquid assets available to banks in the event of a loss of market funding
or of deposits in a bank run. The FSI of liquid assets to total assets, also termed the liquidity
ratio, reveals how vulnerable the banking sector is to a liquidity crisis by indicating how much
balance sheet shrinkage it could absorb due to a loss of access to funding or a bank run before
being forced to sell illiquid assets. The FSI of liquid assets to short-term liabilities measures
liquid assets relative to short-term liabilities that would have to be covered by asset sales if
access to market funding is lost. FSIs of market liquidity monitor current liquidity conditions in
markets for each of the main types of securities that make up the liquid assets of the banking
sector.

Table 1: Financial Soundness Indicators: Core Set

Capital adequacy Regulatory capital to risk-weighted assets

Regulatory Tier I capital to risk-weighted assets
Asset quality Nonperforming loans to total gross loans
Nonperforming loans net of provisions to capital
Sectoral distribution of loans to total loans
Large exposures to capital
Earnings and profitability Return on assets
 [UNCOMPLETE] July 10, 2009

Return on equity
Interest margin to gross income
Noninterest expenses to gross income
Liquidity Liquid assets to total assets (liquid asset ratio)
Liquid assets to short-term liabilities
Sensitivity to market risk Duration of assets
Duration of liabilities

Now we reveal the financial soundness indicators for Bangladesh, India and Pakistan and to
locate our standing means where we are according to others!

Indicators 2004 2005 2006 2007

BNG IND PAK BNG IND PAK BNG IND PAK BNG IND PAK

Risk weighted 6.9 12.8 10.5 7.3 12.3 11.3 5.3 12.3 12.7 7.4 12.6 13.7
capital asset ratio
Gross NPL ratios 17.6 5.2 11.6 13.5 3.3 8.3 13.1 2.5 6.9 13.2 2.8 7.4

Provisions as 19.1 61.5 70.4 24.3 63.6 76.7 26.3 40.0 77.8 42.9 42.8 74.7
proportion of NPLs
Net NPL 14.0 2 3.4 10.1 1.2 1.9 9.5 1 1.5 7.5 1.2 1.8

Return on asset 0.7 0.9 1.2 0.6 0.9 1.9 0.8 0.9 2.1 0.9 1 2.0

Table 2: State of Financial Soundness: Bangladesh India and Pakistan

Table 2 shows that over the year, Bangladesh financial position of Bangladesh banking system
has improved but still generally behind relative to regional comparators.

Stress testing: Basel Proposal

Basle document (Jan ’96) – spells out stress testing as one of the prerequisites for internal model
approval Capital viewed as the last line of defense in a bank. When risk management is
insufficient, when reserves are exhausted, capital absorbs losses to prevent a bank’s failure. But
when capital runs out, the bank may become insolvent, leaving public authorities and taxpayers
responsible for restoring depositors’ savings.

Basel stands on Three Basic Pillars, first of all Minimum Capital Requirement which
provide an economic incentive - in the form of lower capital charges. For those banks that
develop better measures for their exposures to risk and better techniques for managing their
risks. The second strong pillar is Supervisory Review Process which are use to evaluate, how
bank performs internal processes for risk management. Supervisors check that parameters and
conditions used to evaluate risk measures are sound and rigorous. Finally, market discipline
requirements, the third pillar seeks to leverage the ability of markets to provide discipline to
 [UNCOMPLETE] July 10, 2009

banks to ensure that they are not holding unrealistically low levels of capital. Hence, banks
perform stress tests to ensure banks’ capital adequacy in times of shocks.

Now the challenge is determining how much capital is sufficient ?Stress testing is considered to
be an effective and necessary tool that complements statistical models for quantifying &
monitoring risk and capital adequacy By its very nature, stress testing also sets a high qualitative
and quantitative standard for risk management.

Why Stress Testing? Supervisory & Banks’ Expectations:

What does the regulator hope to achieve? What does the bank hope to achieve?

 Able to understand mechanism through  Identify where the risk concentrations

which stress develops. are?
 Able to implement measures when the  Understand impact on bank if biggest
effects of stress events evolve into a customers default?
vicious circle involving the real  Impact on bank if historical worst-case
economy, financial markets and the scenarios recur?
banking sector.  Impact on bank if it is hit by a similar
severe credit loss event that affected
competitors in the past?

The “Stress” Events Occur Anytime, Sometimes Unexpectedly. Negative macroeconomic

environment can create the urgent situation for banks to test their financial fitness. Another
sources of crisis like Oil crisis, high exchange rate, large current account deficit, political &
social instability, Bali bombing, SARS outbreak, general election, or impact of world’s largest
market, US Enron, dotcom bust, post-Sept. 11, or lack of market transparency, analyst & IPO
scandal, unexpected risk from impact of insider trading, opaque corporate governance, post-
irrational exuberance, fear & investor panic leading to short-term funds outflow after bubble
burst etc. are the main sources of banks crisis.

The PRI (Policy Research Institute) Basic Guidelines for SEB (South East Bank) Stress
Testing:

I. Relevance depending on the size and sophistication of institutions:

The Guidelines on stress testing will be applied for SEB based on its size, sophistication and
diversification.

II. Stress testing coverage:

 [UNCOMPLETE] July 10, 2009

SEB should identify their material risks. In general, SEB should conduct adequate and
proportionate stress tests on all the risks they have identified as material.

III. Stress testing calibration:

Based upon the identification of material risks, SEB should derive material risk drivers that
should be subject to stress testing.
Depending on their situation, SEB should consider historical and/or hypothetical scenarios.
Stress testing should be based on exceptional but plausible events.
Stress testing should in principle be applied at the same level as the internal capital adequacy
assessment process (ICAAP).

IV. Frequency and time horizon of stress testing:

The frequency of stress testing should be determined in accordance with the nature of the risks to
which the SEB is exposed and the type of tests performed.
SEB should determine the time horizon of stress testing in accordance with the maturity and
liquidity of the positions stressed where applicable.
Under specific circumstances, supervisors may require institutions to perform ad hoc stress tests
at a specific point in time.

V. Data quality and IT systems:

SEB should use appropriate and representative data when performing stress tests and the IT
resources should be commensurate with the complexity of the techniques and the coverage of
stress tests performed by SEB.

VI. Role of the management body and senior management; reporting and interpretation of
stress testing results:

The SEB management body has the ultimate responsibility for the overall stress testing
framework.
Where appropriate the SEB management body can delegate certain aspects of this framework to
specific risk committees or senior management, keeping the effective oversight.

The stress testing process should be an integral part of the SEB risk management framework,
with clear reporting lines and communication in an understandable format.

Where deemed appropriate by the SEB, it should take remedial measures or actions considering
the level of risk exposure as revealed by stress tests and the objectives and risk tolerances
defined by the management body.

Appropriate documentation should be in place to facilitate the adequate implementation of the

whole stress testing framework.

VII. Review and update of stress testing methodology:

 [UNCOMPLETE] July 10, 2009

SEB should consider periodically whether stress tests are still adequate. In particular, SEB
should ensure that assumptions regarding the risk profile and the external environment are still
valid over time.

Macroeconomic stress tests:

SEB should use stress testing as one (among others) tool to assess the risks in a forward looking
manner.

VIII. Market Risk:

SEB should conduct stress tests for their positions in financial instruments in the trading book.

Principles for SEB using an internal model for the calculation of their market risk
minimum capital requirements.

Credit risk stress testing:

SEB should do the comprehensive method for calculating the effects of financial collateral, or
permitted to use their own estimates of LGDs and conversion factors, should identify conditions
which would adversely affect the realizable value of their financial collateral.

Stress testing for Private commercial bank in Bangladesh: methodology for assessing the
vulnerabilities of the banking system

The model allows applying extreme but plausible shocks, external to the banking sector (interest
and exchange rate shocks) and evaluates their effect, for the purpose of assessing the stability of
the system and identifying potential weak points. In our context, the proposed model allows
plausible shocks such as sectoral shocks like textile or garments, balance of payments shocks,
remittance fall and deposits crisis, external to the banking sector (interest and exchange rate
shocks). Banks needs to evaluate these effects for the purpose of assessing the stability of their
system and identifying the potential weak points.
 [UNCOMPLETE] July 10, 2009

Here in above figure, shows the methodology for assessing the vulnerabilities of the banking
system for our country.

Stress test design for Private commercial bank in Bangladesh:

The shocks affect the banking sector both directly and indirectly. Direct shocks (credit risk) are
represented by the unmitigated effects of economic shocks over the Tier I & Tier II capital and
this effect can arises in our context, if export fall 20 percent or above which increased the
probability of client default. The indirect ones (say liquidity risk), generated by the same
economic shocks, if remittance fall 20 percent or above and banks lost their deposits by
remittance shocks. Now we describe some key concepts to design a formal and convenient stress
test for private commercial bank in Bangladesh.
I. Identifying Major Risks:

To be relevant, stress tests for bank in Bangladesh must probe the consequences of potential
shocks that are related to the macroeconomic risks that exist in the actual situation of the
country. The process of designing system-wide stress tests therefore typically starts with a
discussion of the potential risks faced by the economy. The discussion then suggests that certain
types of shocks (e.g. export shocks or remittance shocks) are more likely in the given economy
than other types of shocks.

The fact that there are macroeconomic risks that could result in shocks to the financial system
does not necessarily mean that the impact of the shocks would be large. The impact can still be
small if the exposures in the system are small. It is the purpose of the stress tests to assess how
the risks combine with the exposures. The design of stress tests is often an iterative process,
since some originally identified risks may lead to relatively small impacts, while some risks
originally assessed as small may lead to large impacts if there are substantial exposures.

Even if the exposures are large and stress tests identify a potentially large impact on the financial
system, it is the purpose of the other parts of the macro prudential analysis to assess the
likelihood that these impacts can be mitigated by prompt action by supervisors and banks.

II. Defining Coverage and Identifying Data:

Another key step in designing stress tests is defining their coverage. The general rule is to
include all systemically relevant exposures. In terms of exposures, the most frequently covered
are exposures to credit risk and market risks, and sometimes also liquidity risk. The choice of
coverage then determines the data needed for the calculation. This section describes the
methodological options concerning the establishing of the crisis scenario and the data
requirements for the considered exposures.

Sample data requirement for the stress test model

Crisis scenario Exchange rate risk Interest rate risk Credit risk Liquidity risk Solvency indicator

Foreign exchange position X

 [UNCOMPLETE] July 10, 2009

Import fall X

Net sensitive assets separated on maturity X

patterns

Balance sheet and profit and loss account for X

economic agents

Export demand fall X

Global meltdown/recession X

Remittance earning shocks X

Own funds X

Risk weighted assets X

Exchange Rate Risk: “Stress Testing 1”

Exchange rate risk is the risk that exchange rate changes affect the local currency value of
Banks’ (and the sector’s) assets and liabilities as well as off-balance sheet items. Exchange rate
risk can arise from positions in foreign currency as well as those in local currency that are
indexed to foreign exchange rates. Furthermore, exchange rate risk can be direct when financial
institutions have positions in foreign currency, or indirect when the foreign exchange positions
taken by the financial institutions’ borrowers may affect their creditworthiness.

Interest Rate Risk:

Interest rate risk is the exposure of a bank’s financial condition to adverse movements in interest
rates. Interest rate changes affect interest income and interest expenses as well as the balance
sheet through changes in market prices of financial instruments. Sources of interest rate risk are
discussed in Basel Committee (2001).

Credit Risk:

Credit risk can be defined as the loss associated with unexpected changes in credit quality.
Despite many innovations in banking, credit risk is typically the most significant source of risk.
The largest source of credit risk is loans; however, it also takes the form of positions in corporate
bonds or transactions on over-the-counter markets, which involve the risk of a default of the
counterparty. More than half of the FSAP missions used NPL-based approaches to modeling
credit risk. About 60 percent of the missions used ad-hoc NPL migration. Only about 30 percent
of the missions found it useful to apply regression analyses to examine the impact of future
potential macroeconomic shocks on the behavior of non-performing loans (IMF and the World
Bank, 2003).

Hypothetical Credit risk test for commercial Banks of Bangladesh

Industrial Export (jute, textile, garments, chemical) fall 20 percent Million Taka

Term loan Nonperforming Nonperforming Total Provision Need to Provision Total Capital Total
2007 Loan for Shocks loan 2007 Nonperforming Maintained Maintained( if 50% (Tier-I+Tier- Adjusted
 [UNCOMPLETE] July 10, 2009

Loan bad loan) II) Capital

South East
Bank 13890.70 2778.14 1551.25 4329.39 473.00 2637.00 6468.36 3831.36

Prime
Bank

BRAC
Bank

Dutch
Bangla
Bank

Islami
Bank

Liquidity Risk:

Liquidity risk is the risk that assets are not readily available to meet a demand for cash. Stress
testing the liquidity of the banking sector involves assessing the impact on the liquidity gap of a
shock such as large-scale deposit withdrawals, a large fall in the price of equities, or an exchange
rate crisis. Modeling liquidity risk is often considered to be much more difficult than modeling
interest rate or exchange rate risk. Many central banks therefore rely on the liquidity stress tests
conducted by the banks themselves. The results of these stress tests are reported off-site, which is
followed-up by integrity checks during on-site visits.

Hypothetical Liquidity risk test for commercial Banks of Bangladesh

Remittance fall 20 percent Million Taka

Deposits Deposits lost for Net deposits Total Cash in Cash in hand Shocks in terms Total Liquid Total Adjusted
2007 Shocks aftershocks 2007 Hand after shocks of assets assets Liquid assets

South East
Bank

Prime Bank

BRAC Bank

Dutch Bangla
Bank

Islami Bank

Interbank Contagion Stress Test:

Interbank stress testing complements the standard set of stress tests by measuring the risk that the
failure of a bank or a group of banks will trigger the failure of other banks within the system.
 [UNCOMPLETE] July 10, 2009

There are a number of interbank contagion channels. The most direct one is contagion through
uncollateralized interbank lending, which was an important transmission channel during the
Asian crisis. The key element of interbank contagion stress test calculations is a matrix of
bilateral interbank exposures (Table 5). The cells of the matrix contain the gross bilateral
interbank exposures between banks, defined as all uncollateralized lending from one bank to
another, covering all on- and off-balance sheet exposures. Each row in the matrix corresponds to
a bank and the cells in the row give its gross interbank exposure with respect to every other bank
in the interbank market.

Table 5: Matrix of Bank-to-Bank Exposures

Islami Bank Prime Bank SEB

Islami ………… Exposure of Islami ………… Exposure of Islam

Bank Bank to Prime Bank bank to SEB

Prime Exposure of Prime ………… ………… Exposure of Prime

Bank Bank to Islami Bank bank to SEB

. . . ………… .
. . . .
SEB Exposure of SEB to Exposure of SEB to …………. ----------
Islami Bank Prime Bank

The pure contagion test assumes that there is a failure in a bank (say, Islami Bank). The failure
can occur for any reason, for instance major export shocks creates higher NPL for IB. The first
round of the contagion calculation would than calculate the direct impact of Islami bank’s failure
on each of the other banks, assuming Islami Bank would not repay its uncollateralized interbank
exposures (or a portion of the exposures). If other banks like prime bank fail as a result of Islami
bank’s failure, the second round of the calculation would calculate the impact on each of the
remaining banks like SEB, of newly failed prime bank not repaying their uncollateralized
interbank exposures. The process can be repeated in a third run if there are new failures after the
second run, and so on.