Stress testingStress testing

Stress testing

An ADI that uses the internal model approach to meet market risk capital requirements must have a comprehensive stress testing program.
An ADI’s stress scenarios must cover a range of factors that can create extraordinary losses or gains in trading portfolios, or make the control of risk in those portfolios very difficult. Stress tests must shed light on the impact of such events on positions that display both linear and non-linear price characteristics (such as options and instruments that have option-like characteristics).
An ADI’s stress tests must be both quantitative and qualitative, incorporating both market risk and liquidity aspects of market disturbances. Quantitative criteria must identify plausible stress scenarios to which an ADI could be exposed. Qualitative criteria must emphasise that the two major goals of stress testing are to evaluate the capacity of the ADI’s capital to absorb potential large losses and to identify steps the ADI can take to reduce its risk and conserve capital.
An ADI must combine the use of supervisory stress scenarios with an internally developed stress testing program that reflects the risk characteristics of the ADI’s portfolio. The ADI must report to APRA information on stress testing as required under Reporting Standard ARS 116.0 Market Risk, and as outlined in paragraph 39 of this Attachment.
An ADI must also develop its own stress tests that it identifies as most adverse based on the characteristics of its portfolio. The ADI must provide APRA with a description of the methodology used to select and to carry out stress tests and include this in the description of the ADI’s management systems. The stress tests must also address:

1. illiquidity/gapping of prices;
2. concentrated positions (in relation to market turnover);
3. one-way markets;
4. non-linear products/deep out-of-the money positions;
5. events and jumps-to-defaults; and
6. other risks that may not be captured appropriately in VaR (e.g. recovery rate uncertainty, implied correlations, or skew risk).

The market shocks applied in the tests must reflect the nature of portfolios and the time it could take to hedge or manage risks under severe market conditions.

An ADI must ensure that the results of the stress tests are reviewed periodically by senior management and reflected in the policies and limits set by management and the Board, or Board committee.