THE revised ‘Stress Testing Guidelines’ issued by the central bank recently has increased the number of specified mandatory tests to 16 against the existing nine that banks are required to carry out on a quarterly basis.

The STGis an improvement over the STG005. It is timely, given the interesting phase of the banking sector’s development. One big public sector bank and four privatised banks largely monopolise the banking operations, particularly, deposits, advances, investments and profits.

The second-tier banks are a mixed lot. Some banks arc earning handsome profits and showing growth, while others are marginally profitable or recording losses. Moreover, nearly half of the second-tier banks are finding it difficult to meet the mandatory minimum capital requirement (MCR).

The STGhas made bank boards responsible for establishing a robust stress testing programme, while the senior management is required to ensure appropriate designing, effective implementation, documentation of applicable policies and procedures and its periodic review together with appropriate stress testing infrastructure with adequate IT systems and resources in place.

The senior management, after reviewing the results of stress tests, is expected to take appropriate actions like reducing risks, putting up additional arrangements for availability of sufficient funds and strengthening the capital base to withstand assumed shocks.

The mandatory tests cover credit, market, and liquidity risk and contain three levels of shocks, which reflect the intensity of the shocks and magnitude of their impact.

While banks (both conventional and Islamic) are required to conduct and report all stress tests, the DFIs need to carry out only eleven of these tests. Stress tests, inevitably subjective, help measure the level of resilience against these ‘what if’ scenarios, which have been designed under plausible but extreme assumptions.

Stress tests traditionally examine the impact of extreme yet plausible scenarios on a given portfolio. Reverse stress tests, as the name implies, overturn this process. For instance, a bank may assume that its CAR drops below the required level of 10 per cent and then identify the potential sources for this problem to materialise. As an extreme case, a bank may assume its insolvency and then identify the factors that can cause such an adverse outcome. Reverse stress testing forces senior management to forensically examine the circumstances that can make their worst fear comes true.

Islamic banking institutions (IBIs) also face unique risks like Shariah noncompliance risk, fiduciary risk, rate of return risk, and displaced commercial risk. Further, transformation of risk from one category to another during different stages of a transaction also complicates the process of scenario selection for IBIs. Such peculiarities necessitate a set of customised stress tests/for designing of which the SBP has provided broad guidance.

Audited accounts of the banks for 2011 have been published. There are instances that one or more banks have high CAR, than the prescribed minimum of 10 per cent and yet they are not in compliance with the MCR prescribed by the SBP. In the case of such a bank if the stress test is carried out, the CAR may still be meeting the prescribed limit. The CAR is the key variable determined after most of the stress tests under different scenarios and for various risks. The SBP may look into the anomaly.

Businesses carry nonloans when there are problems like load shedding of gas and electricity over an extended period, political disturbances, ad hoc policies and decisions. Such things adversely affect profitability/cash generation capability and generate uncertainty. Such uncertainty translates into withholding of payments to creditors. For meaningful analysis, the adverse affects of such factors may also be used in the stress tests.

According to the SBP’s Prudential Regulations, the total outstanding exposure (fund based and nonbase) by a bank/DFI to any single person shall not at any point in time exceed 30 per cent of the bank’s/DFI’s equity as disclosed in the latest audited financial statements, subject to the condition that the maximum outstanding against fund-based exposure does not exceed 20 per cent of the bank’s/DFI’s equity. In simple words, five borrowers could take loans equaling the equity of that bank. This limit is exceptionally high and has the potential to seriously damage a financial institution if one or more such loans turn bad. The limit can be used as a stress test. Downward revision of the limit may be considered.

Inflation in Pakistan hovers around 12 per cent and intermediation margin of banks is around seven per cent. The central bank has fixed minimum profit at six per cent for saving accounts. And the SBP policy rate is at 12 per cent and the banks can deposit their extra liquidity with the SBP earning nine per cent. With intermediation margin of around seven per cent, high profitability of top and most second-tier banks is assured even if large provision for NPLs and write offs is made.

In such a situation, one feels that the banks are being provided an environment in which the risk of loss to the banks is minimal. What is going to happen if intermediation margin reduces to realistic figure of three per cent?

JPMorgan Chase has recently suffered losses of over $2 billion due to faulty trading of derivatives. The bank is big, so it will survive the loss but the shareholders have lost some value and confidence. Rumours are that the bank was also operating as a hedging fund which was governed by relaxed risk management guides as compared to guides applicable on its normal banking operations. This should not have been the case.

The sad experience of this bank perhaps has lessons for the regulators and bank managers in Pakistan. These risk factors can also be used for stress testing:

Quite often the banks are approached by powerful persons or those closely linked to the powerful, to make available loans for their projects in the shortest possible time. The bank board or the senior management are unable to fully resist the pressure and large loans are made available without proper appraisal or procurement monitoring. The entire portfolio is adversely affected.

Is it possible to stress test such situations?Sensitivity and scenario analysis tests are also suggested in matters such as approving private sector large loans, big investments in term-finance certificates or financing of various energy-related projects supported by the government in one way or the other. The findings may be included in the appraisal reports.