Individual risk areas

Institutions should analyse at least:

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:

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.

Institutions should take into account securitisation risks that arise from structured credit products, usually created by repackaging the cash flow from a pool of assets into various tranches or asset-backed securities, taking into account the different positions that institutions can have in the securitisation process, by acting as originator, sponsor or investor.

Institutions should ensure that the stress testing of securitised assets addresses the credit risk of the underlying pool of assets, including the default risk, the possibly non-linear and dynamic default correlations as well as the evolution of the collateral values. Institutions should take into account all relevant information with regard to the specific structure of each securitisation, such as the seniority of the tranche, the thickness of the tranche, credit enhancements and granularity, expressed in terms of the effective number of exposures.

The sensitivity to systemic market effects, affecting, for example, liquidity dry-outs or increasing asset correlations, on all levels of the structured product should be carefully taken into account. In addition, the effect of reputational risks, resulting in, for example, funding issues, should be assessed.

Stress tests should address all relevant contractual arrangements, the potential impact of embedded triggers (e.g. early amortisation provisions), the leverage of the securitisation structure and the liquidity/funding risks arising from the structure (i.e. cash-flow mismatches and prepayment conditions including in relation to interest rate changes).

Scenarios should also consider the default of one or more of the contractual counterparties involved in the securitisation structure, especially of those acting as guarantors of certain tranches.

If the institution relies on external ratings to assess the risk of securitised products, the external ratings should be critically reviewed and scenarios stressing the ratings including the rating classes’ specific impairment rates should be assessed, e.g. by stressing (historical) rating transition matrices.

When designing the stress testing approach, institutions should consider the following:

Institutions should take into account market risk, notably risks derived from losses resulting from adverse changes in the value of positions arising from movements in market prices across commodity, credit, equity, foreign exchange and interest rate risk factors. Interest rate risks in trading book positions should be considered by institutions as a component of market risk.

Institutions should conduct stress tests for their positions in financial instruments in trading and fair value reported in other comprehensive income (FVOCI) portfolios (i.e. accounting terms to classify financial assets), including securitisation instruments/positions and covered bonds. These stress tests should be undertaken as part of institution-wide stress testing as well as for market risk management and calculation purposes.

Institutions should apply a range of severe but plausible scenarios for all positions referred to in the previous paragraph, e.g. exceptional changes in market prices, shortages of liquidity in the markets and the defaulting of large market participants. Dependencies and correlations between different markets and, consequently, adverse changes in correlations should, where appropriate, also be taken into account and factored in. The impact on accounting credit value adjustment (CVA) and on reserves related to institutions’ portfolios (e.g. reserves for liquidity, for modelling uncertainties) should be taken into account equally in stress tests. Market risk reserve stress testing should be substantiated.

When calibrating these stress tests, institutions should take into account at least the nature and characteristics of their portfolios and related financial instruments (e.g. vanilla/exotic products, liquidity, maturity), their trading strategies, and the possibility of, associated cost of and potential time involved in hedging out or managing risks under severe market conditions.

As instruments and trading strategies change over time, institutions should ensure that their stress tests evolve to accommodate those changes.

Institutions should develop an appropriate approach to capturing the underestimation of tail risk by historical data (fat tails) where applicable, e.g. by applying severe hypothetical scenarios, and, where risk is assessed against percentile confidence levels, should consider tail events beyond those confidence levels.

Institutions should in particular:

Institutions should be aware that relevant risk parameters related to operational risk may derive from inadequate or failed internal processes, people and systems, including legal risks, or from external events, and may affect all products and activities within the institution.

In order to stress relevant risk parameters, institutions should use the profit and loss (P&L) effect of operational losses as the main metric. Any intrinsic impact caused by the operational risk event should be considered as an operational risk loss (e.g. intrinsic impacts from opportunity costs, or internal costs such as overtime/bonuses, etc., where they relate to an operational risk event). In addition, and only for the purpose of stress testing, any loss of future earnings caused by operational risk events (excluding second-line effects on the macroeconomic environment) should be included. At least the institutions under the advanced measurement approach (AMA) should also take these losses into account as they flow into the internal loss database to calculate the additional capital requirements. When using historical data, external data or scenarios as inputs for both P&L and RWA projections, institutions should take into account and avoid possible double-counting effects on the input side.

As operational losses may induce second-round effects (i.e. reputational risk), in order to account for such effects, the operational risk stress testing programme should be thoroughly integrated into the institution-wide stress test and should include interconnections with liquidity and own funds requirements. Institutions should analyse at least:

Idiosyncratic risk factors should also be explored and used as inputs for scenario design. Indicatively, institutions under the AMA should stress their business environment and internal control factors (BEICFs).

Institutions should consider the interactions of, and individual exposures to, such idiosyncratic risk factors in determining their operational risk exposure.

Institutions should analyse carefully the possible interaction of operational risk losses with credit and market risks.

The analysis of the stress test events should involve expert judgement, to include at least low-frequency high-severity events.

Institutions should design severe but plausible stress events. Assumptions may differ from assumptions used in credit and market risk stress scenarios. When an institution expands its business in the local or in the international markets through mergers and acquisitions, the design of new products or a new business line, the severe but plausible stress test scenarios should be based on expert judgement to overcome the possible lack of historical information.

Institutions should build their stress testing programme based on both internal and external data, while analysing carefully:

Institutions should take into account that conduct-related risk, as part of legal risk under the scope of operational risk, arises because of the current or prospective risk of losses from the inappropriate supply of financial services and the associated litigation costs, including cases of wilful or negligent misconduct.

In their stress testing, institutions should assess the relevance and significance of the following exposures to conduct-related risk and associated litigation costs:

When measuring conduct-related risk, institutions should consider (a) the uncertainty around provisions or expected losses originating from conduct-related events; and (b) extreme losses associated with tail risks (unexpected losses). Institutions should assess their capital needs under such events and scenarios and should also take into account the reputational effect of conduct losses. In principle, expected losses from known conduct-related issues should be covered by provisions and included in the P&L account, whereas unexpected losses are quantified and covered by capital requirements from the institution. The possible excess of amounts after projection of stressed conduct losses should be included in the institution’s assessment of potential capital needs.

In order to capture the risk that the provisions are insufficient or timely inconsistent, institutions should assess expected losses from conduct-related risk in excess of existing accounting provisions and factor these into their projections. Where appropriate, institutions should assess whether or not future profits will be sufficient to cover these additional losses or costs in the scenarios and incorporate this information into their capital plans.

Institutions should collect and analyse quantitative and qualitative information about the extent of their business in relevant, vulnerable areas. Institutions should also provide information to support material assumptions underlying their estimates of conduct-related costs.

In rare cases where an institution is unable to provide an estimate for an individual material conduct-related risk because of the extent of uncertainty, the institution should clarify that this is the case and provide evidence and assumptions supporting its assessment.

Stress testing should also, where appropriate, be used to assess extreme losses associated with tail risks (unexpected losses) and whether or not additional capital should be held under Pillar 2.

Institutions should form a view on the unexpected losses that may originate from conduct-related events based on a combination of:

Institutions should take into account that liquidity or funding risks arise when an institution is not able to meet current and future cash flows.

Institutions should take into account that liquidity or funding risks encompass:

Institutions should analyse and measure themselves against risk factors relating to both asset- and liability-related items, as well as to off-balance-sheet commitments as defined in the EBA Guidelines on the supervisory review and evaluation process (SREP).

Institutions’ analysis of risk factors should take into account, but should not be limited to:

Institutions should subject these risk factors to sensitivity analyses which in turn should provide the appropriate quantitative background information for the design of scenarios.

Institutions should apply the following three types of stress scenarios: an idiosyncratic scenario, a market-wide scenario and a combination of the two. As idiosyncratic stress scenario should assume institution-specific events (e.g. a rating downgrade, the default of the largest funding counterparty, a loss of market access, a loss of currency convertibility, the default of the counterparty providing the largest inflows), whereas a market-wide stress scenario should assume an impact on a group of institutions or the financial sector as a whole (e.g. a deterioration in funding market conditions or the macroeconomic environment, or rating downgrades of countries in which the institution operates).

Institutions should design different time horizons in their stress testing: the time horizons should range from overnight up to at least 12 months; there should also be separate stress tests relating to intraday liquidity risks. The time horizon should display, for example, a short acute phase of stress (up to 30 days in order to cover such periods without having to change the business model) followed by a longer period of less acute but more prolonged stress (between 3 and 12 months).

Institutions should combine the stress of the short- to medium-term liquidity risk with a stress of funding risk, considering a time horizon of at least 12 months.

Institutions should design a set of adverse behavioural assumptions for customers including depositors, other providers of funds and counterparties for each different scenario and time horizon.

In the design of scenarios, institutions should consider the impact of stress events for other risk types, e.g. credit risk losses and reputational risk events, on their liquidity position, and the possibility of an impact of fire sales from other institutions (e.g. spillovers) or from their own liquidity buffer on the market-to-market value of other assets they hold.

The main methodology used for calculating the magnitude of the impact should be the net cash flow profile. For each scenario, at each stress level, the institution identifies cash inflows and outflows that are projected for each future time period and the resulting net cash flows. Institutions should consider the lowest cumulative point of net cash flows within the time period assessed in each given scenario.

Institutions should extend the analysis, if appropriate, to other metrics, such as:

When applying the different stress scenarios, institutions should assess and highlight counterbalancing effects provided by central banks (monetary policy) and adopt a conservative approach.

Liquidity stress test metrics should include, if appropriate and in particular for at least all material currencies, a granularity per currency to allow the analysis of currency-specific assumptions in scenarios (e.g. volatility in exchange rates or currency mismatches).

Institutions should, where appropriate, integrate liquidity stress test in their institution-wide stress tests, and take into account differences in the time periods covered in liquidity stress tests from those covered in institution-wide solvency stress tests. At a minimum, institutions should assess the impact of increasing funding costs on P&L. Institutions should take into account that linking funding costs to solvency position may influence the quality of the liquidity stress test, namely a too slow deterioration in liquidity.

This section is without prejudice to the EBA Guidelines on interest rate risk arising from non-trading activities.

Stress tests should support and be an integral part of the interest rate risk in the banking book (IRRBB) internal management system.

The interest rate scenarios used for stress testing purposes, including for the purposes of the application of Article 98(5) of Directive 2013/36/EU for the interest rate risk arising from the non-trading activities, should be adequate to identify all material interest rate risks, e.g. gap risk, basis risk and option risk.

Institutions should ensure that the tests referred to in the previous paragraph are not only based on a simple parallel shift but that they consider movements and changes in the shape of the yield curves in their scenario analyses.

Institutions should consider the following elements:

Institutions should be aware of potential indirect interest rate effects triggering losses elsewhere (e.g. that a pass-through onto lending rates could trigger further credit risk losses because of a deterioration in customers’ ability to pay).

Where less complex financial instruments are employed, institutions should calculate the effect of a shock using sensitivity analysis (without the identification of the origin of the shock, and by means of the simple application of the shock to the portfolio). Where an institution uses more complex financial instruments on which the shock has multiple and indirect effects, it should use more advanced approaches with specific definitions of the adverse (stress) situations reflecting relevant idiosyncratic risks.

Stress testing should be a key tool in the identification of concentration risk, as it allows institutions to identify interdependencies between exposures, which may only become apparent in stressed conditions as well as hidden concentrations.

In assessing this risk in their stress testing programmes, institutions should take into account the credit risk of each exposure but also consider the additional sources of risks arising from the similar behaviour of certain exposures (i.e. higher correlation). These additional sources of risk under analysis should cover, but not be limited, to the following:

In stress testing, especially institution-wide and including group stress testing, institutions should assess concentration risk considering on- and off-balance-sheet exposures, as well as banking, trading and hedging positions.

Stress tests should take into account changes in the business environment that may occur and that would lead to the materialisation of concentration risk. In particular, stress tests should consider unusual but plausible changes in correlations between various types of risk factors as well as extreme and unusual changes in risk parameters, going beyond single risk factors, to look at scenarios that take account of interrelated risk factors and that feature not only first-round but also feedback effects.

The way in which concentrated exposures perform in response to the same risk factors should be factored into the stress tests, including the risk of additional short-term losses as a result of concentrated exposures across the retail and corporate credit books or across different entities in a group.

Institutions should consider the impact on trading books from exposures to a single risk factor or from multiple risk factors that are correlated.

In order to assess the ex ante level of concentration risk and/or impact of the scenario on the concentration level, institutions should, where appropriate, consider more or less complex indicators, for instance the Herfindahl-Hirschman Index (HHI) and Gini coefficients.

Institutions should consider the potential existence of overlaps between different concentration sources. Institutions should not simply sum risk impacts but also put in place aggregation methods that consider the underlying drivers.

Institutions should take into account that foreign exchange lending risk:

In their stress testing programmes, institutions should take into account foreign exchange lending risk affecting credit facilities in the asset side of their balance sheet and its multiple sources of risk, taking into account that the debtor’s inability to repay its debt may originate from:

Institutions should consider, when designing or implementing their stress test scenarios, that foreign exchange lending risk impacts may arise from the increase in both the outstanding value of debt and the flow of payments to service such debt, as well as an increase in the outstanding value of debt compared with the value of collateral assets denominated in the domestic currency.

Institutions should develop stress scenarios by changing different parameters to allow them to forecast foreign exchange credit portfolio performances in different cases, such as:

In order to assess potential vulnerability, institutions should be able to demonstrate additional credit risk losses stemming from foreign exchange lending risk separate from the credit risk losses and risk exposure amounts resulting from the impact of the scenario on credit risk factors.

When stress testing the foreign exchange lending risk, institutions should take into account at least:

Institutions should take into account possible significant weaknesses that may be built into internal models with a possible underestimation of currency depreciation in relation to the client’s ability to service its debt, taking into account the following indicative elements:

While assessing the potential impact of foreign exchange lending on profitability in a certain scenario, institutions should, where appropriate, include the legal regime and the relevant jurisdiction, which may force institutions to denominate foreign exchange lending in the domestic currency at exchange rates significantly below market ones.