Guidelines on Stress Testing for Non-Bank

Financial Institutions (NBFIs)

 Introduction to Stress Testing
Stress testing is a simulation technique used to determine the reactions of different Financial Institutions under a set of
exceptional, but plausible assumptions through a series of battery of tests. It is an important risk management tool
used by the FIs as part of their internal risk management to alert management to adverse unexpected outcomes
related to a variety of risks and provides an indication of how much capital might be needed to absorb losses and how
much vulnerable the liquidity position might be if large shocks occur. All the NBFIs are expected to carry out stress
testing on quarterly basis.
After thorough analysis of the situational requirements and future perspectives the guidelines have now been revised
for the NBFIs with the following key aspects:
• Made the guidelines in line with Basel Accord framework;
• Principles for sound Stress Testing practices introduced;
• Standard Shocks levels in four risk areas have been made customized in line with the business of the NBFIs;
• A new financial position indicator, Insolvency Ratio (IR), has been introduced; Liquidity risks have been emphasized
more;
• Stress Test rating scale of 1 to 5 and zonal positioning through Weighted Average Resilience-Weighted Insolvency
Ratio (WAR-WIR) Matrix introduced;
• Artificial Intelligence developed to auto-generate Recommended Action Plan for a particular FI based on its zonal
positioning;
• The Excel based artificial intelligence formats used for Stress Testing have been made more elaborative but simple.
 Scope of Stress Testing
Stress testing guidelines for NBFIs have preliminarily been based on simple
sensitivity analysis using four different risk factors namely; Interest rate,
Credit, Equity price and Liquidity.
Liquidity position of the institutions have been stressed with more concern.
Stress test under Basel Accord and simple maturity gap analysis for measuring
Interest rate risk have been introduced. 'Duration GAP analysis' have been
made simplified for determining the change in market value of equity. Value at
Risk (VaR) has also been incorporated with a view to estimating the actual
amount of potential loss which may arise from unfavorable situations.
Moreover, VaR helps in making a comparison with the result of potential losses
calculated under stress testing system.
 Different Risk Factors
Interest Rate Risks: Interest rate risk is the potential adverse effect in the value of the on
and off-balance sheet positions of the FI with the change in the interest rates. The
vulnerability of the FI towards the adverse movements of the interest rate can be gauged by
using simple sensitivity analysis as well as duration GAP analysis. The standard scenarios of
shock levels are 2%, 4% and 6% increase in interest rate. For simplicity these shocks will be
stress in the cumulative GAP of Rate Sensitive Assets (RSA) and Rate Sensitive Liabilities
(RSL) up to one year and Duration GAP analysis only to the Bond portfolio of the FI.
Credit Risk: Stress test for credit risk assesses the impact of increase in the level of non-
performing loans (NPLs) of the FIs. This involves five individual shocking events. Each
shocking event contains Minor, Moderate and Major Levels of shock.
• Increase in NPLs: These scenarios explain the impact of downgrading a portion of the
total performing (both standard and SMA) loans directly to bad & loss category having
100% provisioning requirement. The standard scenarios of shock levels are 2%, 5% and
10%.
 Different Risk Factors Cont.
• Negative shift in all categories: These scenarios assume negative shifts in all categories (both
performing and nonperforming) take place resulting in more provision requirements. The standard
scenarios of shock (amount of loan shift from one category to another) levels are 5%, 10% and 15%
downward shift in all categories. For example, for the first level of shock, 5% of the standard
downgraded to SMA, 5% of the SMA downgraded to substandard, 5% of the substandard downgraded
to doubtful and 5% of the doubtful downgraded to bad/loss category.
• Fall in the value of eligible securities (VES): These scenarios assume a sharp decrease in the value of
VES creating shocking events to the FI. The standard scenarios of shock levels are 10%, 25% and 50%.
• Increase of NPLs in particular 2 sectors: This measures the concentration risk particularly in 2 sectors
where the FI has the highest investment or exposure. The standard scenarios of shock levels are 5%,
10% and 15% of standard loans of that 2 sectors directly downgraded to bad/loss category.
• Increase in NPLs due to default of top large borrowers: These scenarios are constituted assuming a
number of top borrowers of the FI may become defaulter and create shocking events. The standard
scenarios of shock levels are: default of top 3(three), top 5(five) and top 10(ten) borrowers. In all cases
the standard loans of the respective borrowers are assumed to be directly downgraded to bad/loss
category creating a requirement of 100% provision.
 Different Risk Factors Cont.
Equity Price Risk: The stress test for equity price risk assesses the impact of the fall in the stock market
index. Appropriate shocks will have to be absorbed to the respective securities if the current market value
of all the on balance sheet and off balance sheet securities listed on the stock exchanges including shares,
NIT units, mutual funds etc. falls at the rate of 10%, 25% and 50% respectively. The impact of resultant
loss will be calibrated in the CAR.
Liquidity Risk: The stress test for liquidity risk evaluates the resilience of the FIs towards adverse shifts in
the cash inflow and outflow maturity buckets. Assumed shock scenarios include cash inflow from assets in
projected buckets are being deferred by a standard rates to the next buckets but cash outflow claims for
liabilities are coming much earlier showing claims from all buckets shifting in the previous by the standard
rates. Counter balancing capacity of the FIs are also being stressed using the standard shocks assuming
the market getting a chronic downturn. For simple sensitivity analysis, counterbalancing capacity of the FI
is assumed to be 50% of its first line of defense (line of credit (SOD)) and 20% of its second line of defense
(short-term loan, commercial paper, bill discounting facility). The standard scenarios of shock levels are
5%, 7% and 10%.
Combined Shock: FI will assess combined shock by aggregating the results of credit shock, equity shock
and interest rate shock. In case of credit shock, increase in NPLs, results of increase in NPLs due to default
of Top large borrowers, fall in the VES, negative shift in all the categories and increase of NPLs in
particular 2 sectors would have to be taken into account.
 Different Risk Factors Cont.
Summary of all shocks level:
 Insolvency Ratio (IR)
The NPL to Loan Ratio of an FI is said as the Infection Ratio. Infection Ratio which can completely erode
the regulatory capital of the FI to zero is the Critical Infection Ratio (CIR). CIR implies Distance to Default
or Insolvency. Computation of CIR assumes the erosion of full regulatory capital due to increase in NPL in
Bad/Loss Category ignoring the tax impact. The higher the CIR, the stable the FI is and the lower the CIR
the closer the FI is to default. Insolvency ratio is the ratio of Infection Ratio to the Critical Infection Ratio.
IR implies the percentage, an FI is, towards insolvency. Simplified formula to calculate IR is:

For Stress Testing, after shock IR is computed using the average revised NPL and Average revised
Regulatory Capital of standard shock scenarios in four Credit risk areas, namely: increase in NPLs,
Downward shift in all Categories, Increase in NPLs' under B/L category in 2 sectors and Increase in NPLs'
due to Top large borrowers.
 Resilience of the FI

Resilience Level for Interest rate, Credit and Equity price shocks are set with the Minimum
Capital Adequacy Ratio (CAR). In the stress test it is checked whether an FI has adequate
capital base after the shock impact. Resilience Level for Liquidity shocks are identified with
the following three parameters: Negative gap during 1-90 days’ time buckets exceed 15% .
The cumulative gap up to the one-year period exceeds 15%. Counter balancing capacity up to
the one-year period dry out.
 Stress Test Rating
After conducting the stress test, each FI will be categorized as of either Green or Yellow or Red zone based on the
Weighted Average Resilience (WAR) on the three levels of shock scenarios. The FIs will first be scored in each level of
scenario keeping a total point of 100 for each. When scoring for each level Interest Rate shock will have 10% weight,
Credit Risk 60%, Equity Price Risk 10% and Liquidity Risk 20%. The 60% weight for Credit risk will be subdivided as 10%
for increase in NPLs, 10% for Downward shift in all Categories, 5% for Fall in the VES, 15% for Increase in NPLs' under
B/L category in 2 sectors and 20% for Increase in NPLs' due to Top large borrowers.
Scores achieved in each scenario will then be given weight as 50% for Minor, 30% for Moderate and 20% for Major level
shocks to identify the combined WAR of a particular FI. The WAR will be scaled in rating of 1 to 5 of which 1 fall in Green,
2 and 3 in Yellow and 4 and 5 in Red Zone. For each individual shock Green will achieve 100% of the shock weight, Yellow
80% and Red null. For Interest rate, Credit and Equity price shocks extra CAR of 2% or more above the minimum is
Green, close above or equal to minimum CAR (extra is less than 2%) is Yellow and falling short from minimum CAR is
Red. For Liquidity shocks not falling short in any parameter is Green, short in one is Yellow and falling short in more
than one is Red. The ratings for stress test shocks are summarized below:
 Stress Test Rating Cont.
Insolvency ratio, percentage towards insolvency will also be scaled in 1 to 5 grades after computing the
Weighted Insolvency Ratio (WIR) from the three shock levels and set the Green, Yellow or Red zone
depending on the farness from insolvency. WIR ratings will be assigned as under:

WAR-WIR Matrix: Overall financial strength and resilience of an NBFI will be identified plotting its achieved ratings
in the WAR-WIR Matrix. WAR and WIR of the particular FI will be used to determine its adequate capital
requirement in Basel Accord and will be impacted on the CAMELS rating conducted by the central bank. The overall
zone setting of an FI will be determined with 80% weight of WAR and 20% weight of WIR as under:
 Recommended Action Plan
FIs falling in either zone will have some Recommended Action Plan for securing continuous improvement
in the stress test. The level of score for each zone will be set by the central bank from time to time
considering the prevailing market condition. Present level of score for zonal segregation and respective
to-do list is as follows, as and when applicable:
 Interest Rate Stress Test
For simple Sensitivity analysis:
• Calculate all on-balance sheet Rate Sensitive Assets (RSA) and Rate Sensitive Liabilities (RSL).
• Plot the RSA and RSL into different time buckets on the basis of maturity.
• Calculate maturity GAP by deducting RSL from RSA (GAP= RSA - RSL).
• Using the formula of NII = i (GAP)
For Duration Gap analysis:
• Estimate the market value of all on-balance sheet rate sensitive assets and liabilities of the FI to arrive at market value
of equity.
• Calculate the durations of each class of asset and the liability of the on-balance sheet portfolio and arrive at the
aggregate weighted average duration of assets and liabilities.
• Calculate the duration GAP by subtracting aggregate duration of liabilities from that of assets.
• Estimate the changes in the economic value of equity due to change in interest rates on on-balance sheet positions
along the three interest rate changes.
• Calculate surplus/(deficit) on off-balance sheet items under the assumption of three different interest rate changes.
• Estimate the impact of the net change (both for on-balance sheet and off-balance sheet) in the market value of equity
on the capital adequacy ratio (CAR).
Input and Output Formats