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Malaysia Banks Guidelines on Stress Testing – An Overview and Summary of Requirements

By: Staff Editor
Date: April 11, 2013

Bank Negara Malaysia (BNM) implemented stress testing guidelines for banks in the country in 2007. These guidelines emphasize the importance of stress testing as a risk management tool. This article provides an overview of the requirements included in the guidelines.

According to the guidelines, the role of management is crucial in making the stress test an integral part of the institution’s risk management. Licensed institutions are encouraged to develop stress tests appropriate and effective for their business environment and profile.

Role of Stress Testing

Stress testing has become a standard risk management tool for licensed institutions to understand the nature of their risk profile and the risk drivers.
Stress testing involves identifying potential vulnerable risk areas, establishing their impact and preparing for them.
Sound stress testing processes can be used in the assessment of capital adequacy.
Stress testing should be both rigorous and forward looking.
Stress testing serves as a business decision making tool for undertaking new business activities, entering new markets or undertaking strategic initiatives like mergers and acquisitions.

Licensed Institutions

These guidelines are applicable to the following licensed institutions:

Commercial banks, finance companies and merchant banks / investment banks licensed under the Banking and Financial Institutions Act 1989 (BAFIA)
Islamic banking institutions licensed under the Islamic Banking Act 1983
Any other licensed institution specified by Bank Negara Malaysia.

APPROACH TO STRESS TEST BY LICENSED INSTITUTIONS

Coverage and Risk Factors

Stress tests should take into account exceptional but plausible events as well as reflect new concentrations of risks that may emerge, contagion effect and failure of hedging techniques.
Stress tests should cover the full range of material risks at both business unit level and aggregated group basis.
The identification of material risk should include a comprehensive review of the institution’s nature of business and composition of its own portfolio or a review of external environment in which the institution is operating that would affect its financial conditions.
The licensed institutions should include the following risk factors when constructing the stress test:
- Macroeconomic factors (interest rates, foreign exchange rates, inflation, GDP growth, unemployment rate, asset prices, sentiment index)
- Geographical and political factors (health of other economies, vulnerabilities to external events, contagion effects)
- Financial market conditions (liquidity)
- Concentration risks (borrowers, industries, regions)
- Borrower risk characteristics that would affect obligor risks and increase the default probabilities (for example, borrower type, demographics, industry)
- Transaction risk characteristics (product, collateral type, loan to value ratio, guarantees, seniority)
- Other category of risks such as operational risk.
The stress tests should also reflect the specific risk characteristics of the licensed institutions such as mergers or strategic acquisitions.

Frequency

The frequency of stress testing should be determined in accordance with the nature of the risks which the licensed institutions are exposed to and the types of test performed.
Stress tests should be produced regularly enough to take account of changing market conditions and the licensed institution’s changing risk profile.

Magnitude of Shock

Licensed institutions may vary the level of stress to assess its vulnerability under different scenarios.
The time interval should include at least one business cycle (appropriate to the portfolio).
The magnitude of the shock used should be greater than the conservative estimate of potential losses over the business cycle.
The shocks should be forward looking and also have some relevance to the current events. There can be some reference to historical events, if required.

Second-Round Effects

It is also important to capture the second round or spillover effect that might arise from the original shock.

SPECIFIC REQUIREMENTS BY BANK NEGARA MALAYSIA

Licensed Institutions Should Conduct Own Stress Tests

Licensed institutions are encouraged to explore, design and develop their own stress test that would be most appropriate and effective for their business environment and profile.
Bank Negara Malaysia will evaluate the licensed institution’s stress test program for the appropriateness of stress testing methodologies and governance arrangements.

Effective Board and Management Oversight

The Board of Directors and senior management should exercise effective oversight of the stress test process and ensure that the requirements set out in these guidelines are met.
The Board should assess and approve stress testing policies, procedures and processes.
The Board and senior management should ensure that the management of the stress test process is consistent with the licensed institution’s capital strength, management expertise and risk profile.
The senior management should be actively involved in the process of designing the stress tests program.
The results of the stress test should be communicated to the senior management, the Board and the Risk Management Committee.
Senior management should be responsible for outlining plans to ensure that corrective actions are taken and monitored.
IT systems, human resources, procedures and documentation should be adequate to allow management to identify, quantify, assess and manage efficiently the stresses.
Formal lines of authority and the appropriate separation of duties should be established.

Minimum Requirements for Stress Tests Conducted by Licensed Institutions

All material risks faced by the licensed institution must be included.
The second round or spillover effects of events on the portfolio or business must be taken into account.
The magnitude of the shocks should be large enough to stress the portfolio and should be larger than a regular/cyclical variation.
Stress tests conducted should include at least a scenario that is based on an exceptional but plausible event.
Stress tests must take into consideration the latest development from the economic, political, geographical and global perspectives.
The stress event should exist for a period of time.
Licensed institutions should include its subsidiaries and associate companies if the risks are material

Reporting to Bank Negara Malaysia

Licensed institutions are required to report the results of the stress tests conducted to Bank Negara Malaysia on a regular basis.
Bank Negara Malaysia may require licensed institutions to conduct stress tests based on specified scenarios and to submit the results as well.

Additional Resources

Read the Malaysian Guidelines for Banks' Stress Tests in full here.