Credit and counterparty risks
Institutions should analyse at least:
a borrower’s ability to repay their obligations, e.g. the PD;
the recovery rate in the event of a borrower defaulting including the deterioration of the collateral values or credit worthiness of the guarantee provider, e.g. the LGD; and
the size and dynamics of credit exposure, including the effect of undrawn commitments from borrowers, e.g. the exposure at default (EAD).
Institutions should ensure that their institution-wide credit risk stress tests cover all their positions in their banking and trading book, including hedging positions and central clearing house exposures.
Institutions should endeavour to determine specific risk factors and set out, on a preliminary basis, how these factors can affect their total credit risk losses and capital requirements. Institutions should endeavour to make that determination on an exposure class by exposure class basis (e.g. factors relevant to mortgages may be different from those relevant to corporate asset classes).
Institutions should ensure that credit risk is assessed at various levels of shock scenarios, from simple sensitivity analyses to institution-wide stress tests, or to group-wide stress tests, in particular:
market-wide shock scenarios (e.g. a sharp slowdown of the economy that affects portfolio quality for all of the creditors);
counterparty-specific and idiosyncratic shock scenarios (e.g. bankruptcy of the largest bank creditor);
sector-specific and region-specific shock scenarios; and
a combination of the above.
Institutions should subject risk factors to sensitivity analyses, which in turn should provide quantitative background information for the design of scenarios.
Institutions should apply different time horizons when applying their stress scenarios. The time horizon should range from overnight (one-off effects) up to longer terms (e.g. a creeping economic downturn).
When stress testing financial collateral values, institutions should identify conditions that would adversely affect the realisable value of their collateral positions including deterioration in the credit quality of collateral issuers or market illiquidity.
In the design of scenarios, institutions should consider the impact of stress events on other risk types, e.g. liquidity risk and market risk and the possibility of spillovers between institutions.
Institutions should quantify the impact of the scenario in terms of credit losses (i.e. provisions), risk exposures, income and own funds requirements. In addition, institutions should be able to quantify such impacts by relevant segments/portfolios.
Institutions should consider, wherever possible, the following relevant parameters: PD, LGD, EAD, expected loss (EL) and risk exposure amount, and the impact on credit losses and own funds requirements.
For the estimation of future losses in stress tests, institutions should, where appropriate, rely on credit risk parameters different from the ones applied in the calculation of capital requirements, which are usually through-the-cycle or hybrid parameters (a combination of through-the-cycle and point-in-time parameters) for PD and under downturn conditions for LGD. In particular, institutions should, where relevant, apply estimates based on point-in-time parameters in accordance with the severity of the scenario for the purpose of estimating credit losses.
For the computation of EAD, an institution should also consider a credit conversion factor (CCF) and, in particular, the effect of the institution’s legal capacity to unilaterally cancel undrawn amounts of committed credit facilities especially in stressed conditions.
Institutions should apply, to the extent appropriate, credit risk internal model approaches that challenge historical relations and data, and simulations of credit quality migrations among categories of exposures to provide an estimate of losses.
When assessing their risk to leveraged counterparties or shadow banking entities, institutions should take into account risk concentrations and they should not presume the existence of collateral or continuous re-margining agreements, which may not be available in case of severe market shocks. Institutions should endeavour to capture such correlated tail risks adequately.