Basel panel for focus on stress testing

Committee suggests forward-looking risk assessment by banks to avoid financial crisis in future.

The Basel Committee on Banking Supervision today unveiled a new framework of principles on how to implement stress-testing practices, which were neglected by leading global banks that are now caught in the financial implosion, analysts said.

Entrusted with the responsibility of tightening regulation and supervision in global banks that suffered huge losses — now estimated at over $1 trillion — during the last one year, the Basel Committee has embarked on a series of measures to ensure proper regulation within banks.

It has secured a strong mandate from the leaders of G-20 countries, who met in Washington last year to prepare the ground for tightened supervision and regulation of banks.

The committee operates from the Bank for International Settlements, the watchdog for central banks in the world.

“Stress testing is an important risk management tool,” said Nout Wellink, Chairman of the Basel Committee on Banking Supervision and President of the Netherlands Bank. “It plays a critical role in strengthening not only bank corporate governance but also the resilience of individual banks and the financial system,” he said.

“The financial crisis has demonstrated the importance of stress testing as an integral part of any bank’s risk management, liquidity and capital planning process,” the chairman said.

In its latest paper issued today, the Committee proposed a set of principles to address “weaknesses in stress testing exposed by the financial crisis.” The principles include the underestimation of the potential severity and duration of stress events and the insufficient identification and aggregation of risks on a firm-wide basis.

It “sets expectations for the role and responsibilities of supervisors in reviewing firms’ stress testing practices,” the panel said. Further, the new framework of principles emphases that a sound stress-testing programme must include some key benchmarks. First, the stress-testing practices should be “directed by the board and senior management.” Second, banks must provide “forward-looking assessment of risk” and “complement information from models and historical data.” Third, the practices should be “an integral part of capital and liquidity planning” and “guide the setting of a bank’s risk tolerance.” And, “facilitate the development of risk mitigation or contingency plans across a range of stressed conditions.”

In a separate development, the European Central Bank is considering to further reduce its borrowing cost that are well above the rates in the United States and Japan. As overall inflation rate fell down to the lowest level in more than two years in December, the ECB is provided with enough room to consider further interest rate cuts, which have been reduced by 1.75 percentage points since early October.

Latest estimates suggest the consumer-price inflation in the euro area slowed to 1.6 per cent from 2.1 per cent in November, a development that brings below the ECB’s target of 2 per cent. The fall in inflation rate is made possible due to sharply falling oil prices, analysts said.

Last month, the ECB predicted the euro-area economy will shrink about 0.5 per cent this year, which would be the first annual fall in gross domestic product since the euro’s introduction a decade ago.