Banks to stress test asset portfolios

MONETARY POLICY 2006-07

The Reserve Bank of India (RBI) said it would ask banks to undertake stress tests on their asset portfolios, which would in part be preparedness for implementation of the revised capital adequacy framework, popularly called Basel-II norms.

In the present liberalised environment, banks need to have a robust and sound stress testing process for assessment of capital adequacy.

The stress testing involves identifying possible events and future economic conditions that could unfavourably impact banks' credit exposures and making an assessment of banks' ability to withstand the loss arising out of such events, the RBI said in the policy .

The central bank said it would issue final guidelines on implementation of the new capital adequacy framework after taking into account the recommendations of an in-house group. The RBI had issued draft guidelines in February 2005.

Stress tests would enable banks to assess the risk more accurately and, thereby, facilitate planning for appropriate capital requirements. Stress tests on asset portfolios also need to incorporate various scenarios like economic downturn, industrial downturn, market risk events and sudden shifts in liquidity conditions.

Exposures to sensitive sectors and high risk category of assets would have to be subjected to more frequent stress tests based on realistic assumptions for asset price movements.

G V Nageswara Rao, managing director and CEO, IDBI commercial banking SBU, said, "Stress testing is one of the best practices in risk management, especially with regard to credit and market risk. Although the modalities have not been articulated, from the market risk perspective, we are clearly witnessing a rising interest rate scenario. Hence, banks need to be conscious of the various risks they might encounter during phases of asset-liability mismatches. Stress testing would facilitate quantification of risks banks could run into in case of adverse movements in the interest rates."