Banks asked to check if they can face testing times

The Reserve Bank of India (RBI) has directed bank boards to put in place stress testing models to assess the possible impact of unforeseen financial contingencies on banks.

These contingencies include rising interest rates, and economic and sectoral downturns. Banks will have to put in place a stress test framework by September 30.

As banks would need time to undertake stress tests on a trial basis and use their results to refine the framework, the banking regulator has asked them to have a formal stress testing framework in operation from March 31, 2008.

"Stress test results could be used for setting risk limits, allocating capital for various risks, managing risk exposures, and putting in place appropriate contingency plans for meeting situations that may arise under adverse circumstances," said the RBI in a notification.

Banks will have to conduct sensitivity tests which are normally used to assess the impact of a change in one variable. These include a high magnitude parallel shift in the yield curve, a significant movement in foreign exchange rates, and a large movement in the equity index and liquidity.

Additionally, banks would have to conduct scenario tests based on a single event experienced in the past. Among these are natural disasters, stock market crash, depletion of a country's foreign exchange reserves and a plausible market happening that has not yet taken place.

Also to be assessed are the impact of events like the collapse of communication systems in the country on the bank's financial position.