Stress Testing of the Banking Sector in Credit Risk Framework

Under the Basel framework banks are required to conduct stress tests for their requirements of potential capital while considering the impact of stress testing scenarios. There could exist inter-linkages among macro- economic indicators and financial performance such that the stressed credit quality can be explained. The capital ratio for the banking sector as a whole will be lower when the credit quality at the macro level worsens. We propose a stress testing framework that simulates the credit quality and the capital ratio levels using gross non-performing assets (GNPA) and net non performing assets (NNPA) in presence of both the banks’ performance measures and macro-economic indicators. We define stress testing scenarios assuming multivariate normal distribution using cholesky decomposition of such indicators and evaluate the stressed credit quality and resulting impact on the capital reserves ratio levels. We compare our results with the previous Financial Stability Report (June 2010) of RBI (which uses historical “piece wise” stress testing approach) also based on scenarios of multivariate distribution of stressed factors. We conclude that the banking sector needs to stress their capital ratio levels both with respect to their own performance and few economic factors. Based on a study of top 17 banks that comprise over 40% of the total lending, over 6 years time period (2002-2007), we find that the minimum capital adequacy ratio levels (CAR) could fall to 8-9% against a gross non performing assets (GNPA) over 16%-17%.The rest of the results of the study are in line with previous studies for other countries and provide important insight to the bankers and policy makers