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  • ST-2 ST-2 Major Risks and Stress Scenarios

    • ST-2.1 ST-2.1 Risks and Stress Scenarios

      • ST-2.1.1

        This chapter outlines various risk factors and stress scenarios which the conventional bank licensees should take into account in their stress testing programme.

        July 2018

      • ST-2.1.2

        Conventional bank licensees must identify stress scenarios and risk factors which are aligned to the nature and complexity of the business and markets they operate in. They must ensure that important risk factors or relationships between these factors are not omitted from the stress testing analysis. The risk factors identified will form the basis for developing stress scenarios. Banks must ensure that they have the capacity to conduct integrated stress tests by using a combination of the stress scenarios most relevant to their risk profiles and activities, covering the major types of risk to which they are exposed.

        July 2018

    • ST-2.2 ST-2.2 Risk Factors

      • ST-2.2.1

        A key step in the stress testing process is the identification of major risk factors that should be stressed. In drawing up the list of risk factors, conventional bank licensees must understand the risk characteristics of their exposures and analyse the relevant risk factors, as well as the correlation (and potential for change in correlation) between these factors.

        July 2018

      • ST-2.2.2

        Highlighted below are some examples of risk factors that may be relevant to the conventional bank licensees:

        (a) Credit risk characterised by an increase in default probabilities (e.g. the rise in delinquencies and charge-offs); a decline in recovery rates or in the value of supporting collateral; a rating migration of counterparties, issuers or credit protection providers; and worsening of credit spreads. Banks should be aware of the major drivers of repayment ability (such as economic downturns and significant market shocks) that will affect all classes of counterparties or credits;
        (b) Concentration risk in terms of the large chunks of exposures to individual counterparties, products/-instruments, industries, market sectors, countries or regions which are driven by the same risk factors. Banks should also assess the contagion effects and possible linkages (and the potential changes in such interrelationships, both over time and in times of stress) which may lead to a disproportionate increase in risk exposure;
        (c) Interest rate risk arising from parallel shifts or twists in the yield curve and the increase in basis risk (i.e. changes in relationships between key market rates);
        (d) Market or price risk arising from adverse changes in the price or fair value of assets (e.g. currencies, equities, commodities or other financial instruments and their derivative positions) and their impact on relevant portfolios and markets;
        (e) Liquidity risk as a result of the tightening of credit lines, tightening of secured or unsecured funding markets, market liquidity for certain asset classes, the triggering of obligations to provide additional collateral or margin under credit support agreements or unexpected increase in drawdown of credit lines and deposits;
        (f) Operational risk (including legal risk) caused by various factors, such as internal or external fraud, system failure and security risks (e.g. in respect of transactional e-banking services), and litigation cases that may lead to material monetary loss or reputational impact on the bank concerned, if the outcome is not in its favour;
        (g) Strategic risk resulting from events or changes in the environment that could adversely alter the original assumptions made in the strategic plan and any potential threats to a bank's business, both financially and non-financially;
        (h) Reputational risk stress testing in terms of identifying scenarios (may be due to misconduct, financial crime, market view about the stability of the bank) which will have a negative reputational impact and, in turn, result in increased credit risk (e.g. run on the bank), liquidity risk (tightened access to funding markets) or market risk (drop in equity value).
        (i) Product-specific risks, such as prepayment risk for mortgages, or securitized portfolios. Other potential risks may also arise from abnormal market movements and their impact on contingent credit exposures (e.g. derivatives) and complex products (e.g. structured products with embedded multiple risks);
        (j) System-wide interactions and feedback effects that reflect the impact of likely behavioural responses of other market participants and their counterparties on the broader market in times of stress, and how that impact will feed back to the bank's own positions;
        (k) Macroeconomic factors (e.g. gross domestic product ('GDP') growth, change in property prices, unemployment rate and inflation or deflation rate) and their impact on other risk factors; and
        (l) Political and economic factors pertaining to industries, regions and markets.
        July 2018

    • ST-2.3 ST-2.3 Stress Scenarios

      • Credit and Counterparty Credit Risk

        • ST-2.3.1

          The following are examples of stress scenarios relatingto credit risk and counterparty credit risk:

          (a) Domestic economic downturn — this estimates the impact on a bank's asset quality, impairment provisions, profitability and capital adequacy of adverse changes in selected macroeconomic variables (e.g. GDP growth, unemployment rate, interest rates, bankruptcy rates and asset prices etc.) that are relevant to the bank's exposures;
          (b) Economic downturn in major economies affecting Bahrain (e.g. U.S., Saudi Arabia, UAE etc.) — this estimates the impact on a bank's counterparty exposures (e.g. corporate loans, holdings in securities, interbank exposures etc.) as a result of economic downturn in major economies that have significant financial/commercial/trading links with Bahrain;
          (c) Decline in the real estate market — this estimates the impact of a decline in property prices on collateral coverage, default risk and provisioning needs for loans secured by properties;
          (d) Decline in the value and market liquidity of financial collateral — this estimates the impact of a decline in the valuation and market liquidity of financial collateral, which reduces the quality and quantity of the collateral, leading to lower collateral coverage and recovery rates and higher provisioning needs and capital charges;
          (e) Increases in non-performing loans ('NPL') and provisioning levels — this assesses the resilience of a bank's loan portfolios in terms of the impact of such increases on its profitability and capital adequacy. In designing the scenario, the bank may apply different percentages of increase in classified loans and provisioning levels to its loan portfolios;
          (f) Rating migration of counterparties — a test based on the internal or external credit ratings of bank's credit exposures, by migrating a certain percentage of the credit exposures of a specific rating grade (by one or more notches) to a lower rating grade, and assessing the resultant impact on a bank's profitability and capital adequacy. The capital impact may include the effects of increases in credit losses and provisioning needs, as well as the application of higher risk-weights due to rating downgrades in the calculation of regulatory capital; and
          (g) Default of major counterparties — this estimates the impact of default of a bank's major counterparties, including corporate, sovereign and bank counterparties, on its profitability, as well as liquidity and capital adequacy. The test can be extended to cover aggregate exposures to major industries, market sectors, countries and regions (e.g. by assuming that a significant number of defaults occur within such aggregate exposures).
          July 2018

        • ST-2.3.2

          For the purpose of stressed expected loss, default probabiltiies should be point in time estimates. For a three year stress testing time horizon the bank should estimate the metric for 12th, 24th and the 36th month from the reporting date. This PDs should be cumulative.

          July 2018

      • Interest Rate Risk in Banking Book

        • ST-2.3.3

          The following are examples of stress scenarios relating to interest rate risk in the banking book:

          (a) 'gap risk' arises from the term structure of banking book instruments, and describes the risk arising from the timing of instruments' rate changes. The extent of gap risk depends on whether changes to the term structure of interest rates occur consistently across the yield curve (parallel risk) or differentially by period (non-parallel risk);
          (b) 'basis risk' describes the impact of relative changes in interest rates for financial instruments that have similar tenors but are priced using different interest rate indices; and
          (c) 'option risk' arises from option derivative positions or from optional elements embedded in the bank's assets, liabilities and off-balance sheet items, where the bank or its customer can alter the level and timing of their cash flows. Option risk can be further characterized into automatic option risk and behavioral option risk.
          July 2018

      • Liquidity Risks

        • ST-2.3.4

          The following are examples of stress scenarios relating to liquidity risk:

          (a) Tightening of credit lines — the potential impact of liquidity stress on the solvency position arising from a higher cost of funding due to tightening of wholesale and deposit/funding markets, and loss in the value of marketable securities due to market illiquidity;
          (b) Funding concentration — this assesses the liquidity risk of significant business activities and concentration to a particular source of funding, such as large depositors/funding providers, investment account holders, wholesale market funding or holdings of a particular asset class; and
          (c) Withdrawal risk of investment account holders ('IAH') /deposit outflows — this assesses the liquidity risk arising from honouring redemptions by investment account holders of unrestricted investment accounts at the level of individual funds in case of Islamic windows.
          July 2018

      • Market Risks

        • ST-2.3.5

          The following are examples of stress scenarios relating to market risk:

          (a) Increased volatility in key financial markets assesses the effects of increased volatility and adverse movements of market risk factors (i.e. interest rates, foreign exchange rates and equity or commodity prices) on a bank's market risk exposures;
          (b) Effect of key monetary decisions by the CBB, which might impact stock prices, FX rates and interest rates;
          (c) Effect on the bank arising from a rating downgrade of sovereign, leading to widening of credit spreads and a fall in equity prices; and
          (d) Structural changes to the economy of the main countries in which the bank operates.
          July 2018

      • Other Risks

        • ST-2.3.6

          The following are examples of stress scenarios relating to other risks:

          (a) Decline in net interest income — this estimates the impact on the bank's net interest income due to negative loan growth or squeezes in pricing caused by competition for new business or market share;
          (b) Risk concentrations — this estimates the impact from changes in market conditions which could give rise to risk concentrations. Banks may identify and assess the impact of heightened correlations or hidden inter-dependencies within and across risk types/risk factors, and possible second-round effects under severe market shocks that may lead to an increase in bank's exposures; and
          (c) Operational risk events — this assesses the effects, on a bank's capital requirement for operational risk, or its ability to maintain critical operations and earning capabilities, of external events (e.g. external fraud, vendor failure, utility outage and service disruption) or internal events (e.g. internal fraud, business disruption or system failures, telecommunication problems and loss of key personnel).
          July 2018