The Principles of Banking, 2nd Edition

CHAPTER 20Stress Testing, ICAAP, ILAAP and Reverse Stress Testing¹

Abstract

Stress testing is the process of flexing the balance sheet on paper under different hypothetical market conditions to observe what the impact on the bank's capital and liquidity position would be should the hypothetical scenario or “storyboard” occur in real life. The process is heavily prescribed by banking regulation, which is driven by guidance published by the Basel Committee. We describe the formal capital and liquidity stress testing framework that is given by the “ICAAP” and “ILAAP” processes and also introduce principles and process of a further regulatory requirement, the reverse stress test.

Stress testing and scenario analysis is now an established part of the risk management process in banks. It is a well-established industry now, because it is required of every bank as part of its annual supervision process. So in this chapter we describe the capital adequacy process, known as ICAAP, the liquidity adequacy process, known as ILAAP, and reverse stress testing.

We describe how these processes should be set in a bank, again with an illustration using a template stress-testing policy suitable for most commercial banks.

STRESS TESTING POLICY

Stress testing is now a significant aspect of the bank risk management process, with considerable time and effort expended by senior managers across first line, second line and third line of defence, in subjecting the balance sheet to “scenario analysis”. ...