Background
Globally, banks are increasingly relying on statistical models to measure and manage the financial risks to which they are exposed. These models are gaining credibility because they provide a framework for identifying, analyzing, measuring, communicating and managing these risks. Since models cannot incorporate all possible risk outcomes and are generally not capable of capturing sudden and dramatic changes, banks supplement models with ‘stress tests’.

Sensitivity tests are normally used to assess the impact of change in one variable (for example, a high magnitude parallel shift in the yield curve, a significant movement in the foreign exchange rates, a large movement in the equity index etc.) on the bank’s financial position.

Scenario tests include simultaneous moves in a number of variables (for example, equity prices, oil prices, foreign exchange rates, interest rates, liquidity etc.) based on a single event experienced in the past (i.e., historical scenario – for example, natural disasters, stock market crash, depletion of a country’s foreign exchange reserves) or a plausible market event that has not yet happened (i.e., hypothetical scenario - for example, collapse of communication systems across the entire region/ country, sudden or prolonged severe economic downturn) and the assessment of their impact on the bank’s financial position.

Banks in India are beginning to use statistical models to measure and manage risks. Stress tests are, therefore, relevant for these banks. Further, the supervisory review process under Pillar 2 of Basel II framework is intended not only to ensure that banks have adequate capital to support all the risks in their business, but also to encourage banks to develop and use better risk management techniques in monitoring and managing their risks. RBI in notification dated 26/6/2007 has asked banks to put in place a