Credit risk stress testing
CM-1.4.18
Stress testing must involve identifying possible events or future changes in economic and other conditions that could have unfavourable effects on the
Islamic bank licensee's credit exposures and assessing its ability to withstand such changes. Three areas that thelicensee could usefully examine are: (i) economic or industry downturns; (ii) market risk events; and (iii) liquidity conditions. Stress testing can range from relatively simple alterations in assumptions about one or more financial, structural or economic variables, to the use of highly sophisticated financial models.Added: June 2022CM-1.4.19
Stress tests are to be performed by adjusting the parameters and then recalculating credit losses, for example:
(a) Unfavourable changes (increases/decreases, depending on portfolio composition) in the underlying profit rate by a certain number of basis points; and(b) Unfavourable changes (increases/decreases, depending on portfolio composition) in crucial exchange rates by a certain percentage.Added: June 2022CM-1.4.20
In undertaking
credit risk stress tests,licensees should considercounterparty -based and credit facility-based risk factors and scenarios that help estimate credit losses after modelling a change in probability of default (‘PD’) and/or loss given default (‘LGD’) or exposure at default (‘EAD’). Stress testing programmes should consider:(a) The inclusion of thelicensee’s individual credit portfolio composition and compile a list of the credit products in use;(b) Identify the decisive risk factors for each individual credit product and develop a basis for prioritising the factors by relevance and to group those risk factors which influence each other strongly under normal conditions or in crisis situations for the development of stress tests;(c) Analyse the prevailing social, economic, and political conditions and filter as many potential crisis situations as possible and relevant;(d) Use of in-house as well as external expertise, as appropriate, and ensure that the stress tests attain the necessary level acceptance.Added: June 2022CM-1.4.21
The approaches towards modelling stress tests include the following elements considered individually and on a combined basis as appropriate and with varying severity:
(a) Downgrading all obligors by one rating class;(b) Increasing default probabilities by a certain percentage;(c) Increasing LGD by a certain percentage;(d) Increasing EAD by a certain percentage for variable credit products (justification:customer s are likely to utilize credit lines more heavily in crisis situations, for example);(e) Assumption of negative credit spread developments forSukuk s;(f) Modelling of input factors (e.g. balance sheet indicators).Added: June 2022CM-1.4.22
Additionally, the impact of macroeconomic risk factors such as fluctuations in profit rates and/or exchange rates etc. on the following illustrative general conditions may be considered:
(a) Stress tests for specific industries or regions;(b) Downgrading all obligors in one or more crisis-affected industries; and(c) Downgrading all obligors in one or more crisis-affected regions.Added: June 2022CM-1.4.23
If the
licensee uses risk models (such as credit portfolio models or credit pricing models), it is necessary to perform stress tests which show whether the assumptions underlying the risk models will also be fulfilled in crisis situations. Only then will the models be able to provide the appropriate guidance in crisis situations.Added: June 2022CM-1.4.24
Islamic bank licensees should also examine political risk factors when significant parts of the credit portfolio consist of obligors from politically unstable countries. Due to the complex interrelationships involved, however, developing plausible stress tests for political risk factors involves far more effort than designing tests for macroeconomic risk factors. It is, therefore, advisable to call in specialists to develop stress tests for political risk factors in order to assess the relevant effects on financial and macroeconomic conditions.Added: June 2022CM-1.4.25
The output of the stress tests must be reviewed periodically by
senior management and appropriate action taken in cases where the results exceed agreed tolerances. The output must also be incorporated into the process for assigning and updating policy and limits.Added: June 2022CM-1.4.26
Islamic bank licensees must attempt to identify the types of situations, such as economic downturns, both in the whole economy or in particular sectors, higher than expected levels of delinquencies and defaults, or the combinations of credit and market events that could produce substantial losses or liquidity problems.Added: June 2022
