• LM-9 LM-9 Stress Testing and Scenario Analysis

    • LM-9.1 LM-9.1 Overview

      • LM-9.1.1

        In addition to conducting cash flow projections to monitor its liquidity positions under normal business conditions, a bank must regularly perform stress tests based on sufficiently severe but plausible scenarios to identify potential sources of liquidity strain under stressed conditions.

        August 2018

      • LM-9.1.2

        Banks must conduct stress tests based on sufficiently severe, but plausible scenarios and assumptions that are commensurate with the bank's business nature, size and complexity. The stress testing scenarios and assumptions adopted by a bank must reflect the current market conditions and address the bank's actual experiences in stressed situations. Such scenarios and assumptions must be reviewed regularly by the senior management, with any major changes endorsed by the bank's Board or its relevant delegated committee(s). The active involvement of senior management is vital to the stress testing process. During their regular reviews, senior management must consistently require consideration of sufficiently severe stress scenarios.

        August 2018

      • LM-9.1.3

        Stress tests must enable a bank to analyse the impact of stress scenarios on its consolidated group-wide liquidity position, as well as on the liquidity position of individual entities and business lines in order to understand where risks could arise. For the purposes of consolidated liquidity positions, the licensees may use a proportionate or component approach.

        August 2018

      • LM-9.1.4

        Stress tests must be performed for all significant currencies in aggregate and, separately, for positions in BHD or USD in wholesale banks functioning on the basis of a US Dollar based operating model, if relevant, and individual foreign currencies in which banks have significant positions.

        August 2018

      • LM-9.1.5

        The design and frequency of stress testing must be commensurate with the size and complexity of a bank and its liquidity risk exposures.

        August 2018

      • LM-9.1.6

        When conducting stress tests on their liquidity position, banks must also consider the insights and results of stress tests performed for other risks, including possible interaction with these other risks.

        August 2018

    • LM-9.2 LM-9.2 Scenarios and Assumptions

      • LM-9.2.1

        It is important for banks to construct sufficiently severe, but plausible stress scenarios and examine the resultant cash flow needs. While banks should aim to cover different stress events and levels of adversity, they must, at a minimum, include the following types of scenarios in their stress testing exercise:

        (a) An institution-specific stress scenario;
        (b) A general market stress scenario; and
        (c) A combination of both, including possible interaction with other risks.
        August 2018

      • LM-9.2.2

        A bank will need to assign the timing of cash flows for each type of asset and liability, as well as off-balance sheet and contingent items, by assessing the probability of the behaviour of those cash flows under the scenario being examined. The timing of cash inflows and outflows on the maturity ladder can vary among scenarios and the assumptions may differ quite sharply. In estimating liquidity needs, both contractual and non-contractual cash flows should be considered.

        August 2018

      • LM-9.2.3

        In designing stress scenarios, a bank must take into account, specific risks associated with its business activities, products or funding sources. These include, for example, heavy reliance on specific funding markets or significant exposures to complex financial instruments. The stress scenarios must be able to evaluate the potential adverse impact of these factors on the bank's liquidity position.

        August 2018

      • LM-9.2.4

        A bank should take a reasonably conservative approach when setting stress assumptions. There are a number of possible areas that the assumptions should cover. For illustrative purposes, these areas include, but are not limited to, the following:

        (a) The run-off for retail funding;
        (b) Asset market illiquidity and erosion in the value of liquid assets;
        (c) The loss or impairment of secured and unsecured wholesale funding sources;
        (d) The correlation between funding markets and effectiveness of diversification across available sources of funding;
        (e) The availability of contingent lines extended to the banks;
        (f) The availability of funding in different tenors;
        (g) Contingent claims, including potential draws on committed lines extended to third parties or the bank's connected parties (such as its overseas branches, associated entities in its consolidated group, controller or head office);
        (h) Liquidity drains associated with contractual obligations or non-contractual obligations involving off-balance sheet vehicles and activities, as well as complex products or transactions;
        (i) Additional margin calls and collateral requirements (e.g. in derivative or other contracts with embedded trigger clauses);
        (j) Estimates of future balance sheet growth;
        (k) Currency convertibility and access to foreign exchange markets;
        (l) The transferability of liquidity across entities, sectors and jurisdictions, taking into account legal, regulatory, operational and time zone restrictions and constraints;
        (m) Access to the payment and settlement systems which are imperative to a bank.
        (n) The impact of credit rating triggers;
        (o) The access to central bank facilities;
        (p) The operational ability of the bank to monetise assets; and
        (q) The bank's remedial actions and the availability of the necessary documentation and operational expertise and experience to execute them, taking into account the potential reputational impact when executing these actions.
        August 2018

      • LM-9.2.5

        All stress scenarios and their underlying assumptions must be properly defined and documented in the bank's Liquidity Risk Management Policy statement.

        August 2018

      • Institution-specific Stress Scenarios

        • LM-9.2.6

          An institution-specific stress scenario must cover situations that could arise from a bank experiencing either real or perceived problems (e.g. asset quality problems, solvency concerns, credit rating downgrade, rumours relating to the bank's credibility or management fraud, etc.) which affect public confidence in the bank and its firm-wide or group-wide operations. It must represent the bank's view of the behaviour of its cash flows in a sufficiently severe stress scenario. A key assumption is that many of the bank's liabilities cannot be rolled-over or replaced, resulting in the need to utilise its liquidity cushion.

          August 2018

        • LM-9.2.7

          This scenario will likely entail an acute deposit run. Such a scenario would typically include the following characteristics:

          (a) Significant daily run-off rates for deposits particularly at the initial stage of the stress scenario, with increasing requests from customers to redeem their time deposits before maturity;
          (b) Interbank deposits repaid at maturity;
          (c) No new unsecured or secured funding obtainable from the market; and
          (d) Forced sale of marketable securities at discounted prices.
          August 2018

      • General Market Stress Scenarios

        • LM-9.2.8

          A general market stress scenario is one where liquidity, at a large number of financial institutions in one or more markets, is affected. Characteristics of this scenario may include:

          (a) A market-wide liquidity squeeze, with severe contraction in the availability of secured and unsecured funding sources, and a simultaneous drying up of market liquidity in some previously high liquidity markets;
          (b) Substantial discounts needed to sell or repo assets and wide differences in funding access among banks, due to the occurrence of a severe tearing of their perceived credit quality (i.e. flight to quality);
          (c) Restrictions on currency convertibility; and
          (d) Severe operational or settlement disruptions affecting one or more payment or settlement systems.
          August 2018

      • Combined Stress Scenarios

        • LM-9.2.9

          Banks must incorporate a stress scenario into their stress test framework that has the key characteristics of both an institution-specific stress scenario and a general market stress scenario combined ('combined stress scenario'), with appropriate modulations of the underlying assumptions, as necessary, to reflect a set of adverse circumstances that could plausibly happen.

          August 2018

        • LM-9.2.10

          The following are some relevant factors that could be considered in formulating a bank's 'combined stress scenario':

          (a) As a greater number of financial institutions in the market will be affected under a combined stress scenario, this may change the way in which some institution-specific stress elements are to be structured. For example, instead of a quick but severe bank run, there may be a less acute, but more persistent and protracted run-off of customer deposits; and
          (b) Even lower realizable values of assets may result as the bank concerned seeks to sell or repo large quantities of assets when the relevant asset markets become less liquid and market participants are generally in need of liquidity.
          August 2018

      • Minimum Stress Period

        • LM-9.2.11

          Banks must assume the minimum stress period for an institution-specific stress scenario to last for no less than 5 working days, and that for a general market stress scenario and a combined stress scenario to last for no less than one calendar month. However, a bank must adopt a longer minimum stress period for the purposes of liquidity stress-testing if its liquidity risk profile warrants this. To gauge a bank's survival period under stress, it is also generally expected that, in addition to the minimum stress period, the bank's stress test must also include sufficiently granular time-bands to assess the bank's ability to meet its obligations in the near to medium-term.

          August 2018

    • LM-9.3 LM-9.3 Utilisation of Stress Test Results

      • LM-9.3.1

        The stress testing results must be linked to the overall liquidity risk management process of a bank, including the setting of the liquidity risk tolerance and the internal liquidity risk limits). To this end, senior management must:

        (a) Ensure proper documentation of the stress scenarios and related assumptions, and review the scenarios and assumptions periodically;
        (b) Evaluate the stress testing results and consider any possible need for remedial or mitigating actions. Remedial or mitigating actions may include actions to limit the bank's liquidity risk exposures, obtain more long-term funding, restructure the composition of assets, and increase the size of the bank's liquidity cushion or the adoption of any other measures to adjust the bank's liquidity profile to fit its risk tolerance. Where such actions are not considered necessary to address stress test results indicating potential liquidity strains or shortfalls, senior management must document the justifications for their view;
        (c) Report the stress testing results and vulnerabilities identified to the Board (or its relevant delegated committee(s)), with recommendations for any resulting actions. Where appropriate, the CBB must be informed of the results and anticipated actions if they are material to the bank (i.e. in addition to normal stress testing reporting arrangements); and
        (d) Integrate the stress-testing results into the bank's strategic business planning and Contingency Funding Plan ('CFP').
        August 2018