Chapter Five Requirements of Pillar 2 of Basel Accords Part Two: Specific Requirements for Banks' Stress Testing Reports

Introduction

Stress testing is considered one of the most important risk management tools used to assess a bank's ability to withstand shocks and crises under unfavorable conditions. Therefore, it has become necessary for all banks to have comprehensive and detailed stress testing programs. These instructions have been prepared in light of international best practices and in accordance with the provisions of the Central Bank and Banking Law No. 194 of 2020, with the aim of enhancing the supervisory role of the Central Bank of Egypt and achieving financial stability by evaluating the financial soundness and liquidity position of banks, as well as their ability and flexibility to deal with risks under stressed conditions and crises. The results of these tests contribute significantly to making appropriate proactive decisions regarding the bank's overall risk framework, strategy, and action plan. They also play a role in developing contingency plans, business continuity plans, and recovery plans, in addition to enhancing precautionary measures against sudden shocks and crises. They also help banks estimate future capital and liquidity requirements to face various risks.

It is worth noting that these instructions define a general framework for stress tests conducted by banks periodically as part of the risk management process. Compliance with these instructions is required, particularly regarding the requirements set out in Item (9) when preparing the stress testing section of the Internal Capital Adequacy Assessment Report, and submitting this report to the Central Bank annually.

1. Scope of Application

These instructions apply to all banks registered with the Central Bank of Egypt, including branches of foreign banks, as follows:

1-1 On an individual basis (including the bank's branches inside and outside Egypt): For banks that do not have a banking group.

2-1 On an individual and consolidated basis: For banks that have a banking group.

1. Footnote 1: Letter from the Governor of the Central Bank dated March 28, 2024.
2. Footnote 2: Banking Group: Includes the bank and all its branches inside and outside Egypt, and all other financial companies (excluding insurance companies) in which the bank (or the bank and its related parties) owns more than 50% of shareholders' equity or any percentage that enables it to control that entity, as stated in the instructions issued on December 24, 2012, regarding the minimum capital adequacy standard under the implementation of Basel accords.

The following terms have the meanings indicated next to each of them in the application of the provisions of these instructions:

1-2 Stress Tests: One of the risk management tools used to measure the impact of shocks and unfavorable conditions on the continuity of the bank's business, and thus to measure its ability to face risks and shocks.

2-2 Sensitivity Tests: Applying a shock to one variable while keeping other variables constant. These tests provide an initial assessment of the sensitivity of the bank's financial position to a specific risk factor.

3-2 Scenario Tests: Applying multiple shocks to multiple variables simultaneously, taking into account specific assumptions based on historical and/or hypothetical bases, as follows:

1-3-2 Historical Scenario Tests: Rely on fundamental market events that occurred in the past. This type of test does not take into account unknown future risks.

2-3-2 Hypothetical Scenario Tests: Rely on setting up hypothetical scenarios for adverse exceptional conditions, which have a low probability of occurrence but are possible. These tests take into account unknown future risks (for example: risks associated with new products).

4-2 Reverse Stress Tests: In this test, scenarios are prepared by assuming negative outcomes to deduce the assumptions that could lead to these results. An example is preparing scenarios that lead to breaches in some regulatory ratios (capital adequacy ratio, liquidity ratios, etc.) above the prescribed limits.

5-2 Scenario Preparation: The process of envisioning potential developments and unfavorable conditions and assumptions that may negatively affect the bank's financial position during a hypothetical period.

6-2 Scenario Plausibility: Refers to the extent of the scenario's realism, ensuring that assumptions align with the current position of financial and economic variables, taking into account historical events and the likelihood of their occurrence. The scenario should reflect changes in economic conditions that affect the diversity and intensity of risks surrounding the bank, not just based on historical fluctuations and events.

7-2 Model Risks: Losses that may arise from preparing or using models that are not sufficiently accurate, especially when preparing those models based on the assumption of stability and constancy of assumptions and data used, under conditions that may be unstable (interest rate changes, default, price differences, etc.), which may affect the validity of the expected results of those models. This takes into account the necessity of periodic evaluation of the accuracy of measurement models by comparing the results produced by the model with the actual results for the same time period.

8-2 Contagion and Rapid Spread Risks: Financial risks that may pose a threat to the continuity of the bank's business and may result in an impact on other banks or the financial system as a whole.

9-2 Strategic Risks: Negative effects on the bank's profits and capital resulting from incorrect business policies or decisions, improper implementation of decisions, changes in the business environment, or failure to respond quickly to changes in the surrounding environment.

-3 Objectives of Stress Tests

Stress testing is an important element of risk management, and its application aims to:

1-3 Conduct a forward-looking risk assessment to anticipate the extent of the impact of negative developments on the bank's financial position, either as a result of internal changes or external changes related to the economic environment in which the bank operates.

2-3 Contribute to determining the required capital level and managing liquidity risks.

3-3 Provide the necessary data and information for the Board of Directors to enhance strategic decisions regarding the determination of risk types and levels, as well as identifying latent risks and reviewing acceptable limits for them.

4-3 Contribute to developing risk mitigation methods, contingency plans, business continuity plans, and recovery plans.

5-3 Disseminate the culture of risk management across all bank departments, contributing to enhancing the ability to deal with unfavorable conditions and crises.

6-3 Adopt risk management governance systems and procedures that support rapid response in case the bank is exposed to shocks and crises.

7-3 Enhance internal and external communication for the bank, especially with foreign counterparts, banks, and other relevant parties.

-4 Requirements for Stress Testing Programs

1-4 Banks must have policies approved by the Board of Directors, as well as written work procedures for stress testing programs approved by the competent executive committee and submitted to the Risk Committee. Assumptions used and stress test results must be documented, and those assumptions must be reviewed periodically in light of significant changes, such as those affecting the complexity of banking activities, IT infrastructure, market conditions, and the economic environment.

2-4 Banks must prepare and apply stress testing programs periodically, submitting the report to the Central Bank annually or whenever required (according to the report on stress testing programs as will be mentioned in Item 9). When designing stress testing programs, different perspectives from all bank sectors must be considered, especially the Risk and Treasury sectors.

3-4 Banks must use a set of methods aimed at achieving comprehensive coverage of all risks, with special attention to fundamental risks and other related risk factors, including quantitative and qualitative methods to support risk management and sound strategic decision-making by the Board of Directors.

4-4 The bank must have suitable infrastructure to apply stress testing programs, characterized by sufficient flexibility to conduct various stress tests and any additional or new requirements. This ensures ease of data collection and the ability to retrieve test results for comparison over specific periods and preparing necessary reports for the Board of Directors and senior management when required.

5-4 Stress testing programs must cover both sensitivity tests and scenario tests to include all fundamental risks the bank may be exposed to.

6-4 Stress testing programs must be provided with accurate data in a timely manner, commensurate with the objectives of the applied tests, to ensure the identification of fundamental risks the bank may be exposed to, ensuring the validity of test results.

7-4 Stress testing programs must be commensurate with the size and nature of the bank, the complexity of its activities and business models, and the risks it faces. Therefore, the following factors must be considered at a minimum when conducting stress tests:

1-7-4 Total size of the bank's assets and its subsidiaries, within the scope of consolidated supervision.

2-7-4 The bank's strategy and action plan and their consistency with its organizational structure.

3-7-4 Risk policy, including the bank's acceptable risk level.

4-7-4 Ownership structure and the bank's financial structure.

5-7-4 Classification of the bank's credit portfolio in terms of customer nature (individuals, institutions, SMEs, or government entities) and economic sectors, non-banking financial activities, etc.

6-7-4 Outsourcing service providers, their procedures, services, activities, and distribution channels.

7-7-4 Existing IT systems in the bank, and related contingency and business continuity plans.

8-4 Stress tests must be integrated with the bank's risk management culture and applied policy by providing recommendations, proposals, and necessary corrective actions, ensuring the continuity of the bank's business under unfavorable conditions.

9-4 Stress testing programs must include scenarios that vary in intensity, including severe scenarios (such as periods of sharp and continuous recession, major natural disasters, etc.), to evaluate banks' ability to respond quickly within an appropriate timeframe, with special attention to liquidity and funding risks that may threaten the continuity of the bank's business.

10-4 Stress testing programs must include scenarios related to recovery plan tests, which involve serious events that could threaten the continuity of the bank's business, taking into account the periodic review and update of recovery plans in light of the results of those tests.

11-4 Reverse stress tests must be conducted to identify a scenario or set of scenarios that may negatively affect the continuity of the bank's business (e.g., negative impact on the rapid increase in the ratio of non-performing loans, cyberattacks, etc.). Measures and procedures to be taken in this regard must be determined, which may require re-evaluating the acceptable risk level by the Board of Directors.

12-4 In case of using outsourcing service providers, counterparty risks must be evaluated and included in stress testing programs at the individual bank level and at the banking group level as a whole. Contingency, business continuity, and recovery plans of outsourcing service providers must be evaluated in light of stress test results to assess the effectiveness of communication with them. It is essential to emphasize the availability of necessary data for crisis management and business continuity.

13-4 The impact of stress tests on certain financial indicators of the bank must be measured, taking into account that they are commensurate with the type of test, its objective, the types of risks under test, and the application time frame. They must include at least the following:

1-13-4 Values of assets and liabilities.

2-13-4 Impaired assets, credit rating degree, and the ratio of bad debts to total non-performing loans.

3-13-4 Net profits or losses and their impact on the bank's financial position.

4-13-4 Prescribed ratios for capital adequacy and liquidity.

5-13-4 Current and cumulative liquidity gaps and funding gaps (taking into account the maximum limits of these gaps as a percentage of total liabilities).

-5 Stress Tests According to Risk Types

Stress tests must include risks the bank may be exposed to and evaluate the following risks at a minimum and include them in the report on stress testing programs submitted to the Central Bank (as mentioned in Item 1-5):

1-5 Credit Risk and Counterparty Risk:
The bank must use several levels of shocks when applying stress test scenarios for credit risk and counterparty risk, starting from sensitivity tests (which are less complex) to scenario tests. For example:

1-1-5 Scenarios related to market conditions (such as a sharp economic recession or depression that may negatively affect the quality of the credit portfolio).

2-1-5 Scenarios at the level of the bank's customers (such as the failure of the most influential credit customers of the bank).

3-1-5 Scenarios at the level of affected economic sectors or geographical areas where the bank's activities are concentrated.

4-1-5 Scenarios related to the present value of bank customers' assets and collateral, taking into account factors that may negatively affect them, such as deterioration of the borrower's credit rating, sharp liquidity decline, or changes in market factors (exchange rates and yield rates, etc.).

5-1-5 Aggregated scenarios prepared to evaluate the quality of the credit portfolio, estimating the volume of expected losses resulting from those scenarios.

2-5 Market Risk:

1-2-5 Stress tests for market risk include, for example, losses resulting from negative changes in the present value of the bank's financial investment positions in shares and debt instruments due to changes in interest rates and yield rates. These tests must include financial instruments listed at fair value through profit or loss, and those listed at fair value through other comprehensive income.

2-2-5 Severe scenarios must be applied, including, for example, measuring the impact of exceptional changes in market prices or factors, market liquidity shortage, and failure of the largest market participants, taking into account the correlation between different markets and negative changes resulting from those correlations when conducting the test.

3-5 Liquidity Risk:

1-3-5 Stress tests for liquidity risk aim to evaluate the bank's ability to meet current and future obligations.

2-3-5 Stress tests must include liquidity risk factors related to assets and liabilities, off-balance sheet commitments, and guarantees. They must also include weaknesses in the bank's financing structure at different maturities, the deposit withdrawal rate under normal conditions (which may worsen under stress), concentration in funding sources, and the currency in which assets and liabilities are denominated, which may reflect conversion risks and liquidity difficulties.

3-3-5 The bank must prepare the following scenarios when conducting stress tests, as well as a scenario combining both:

1-3-3-5 Internal scenarios related to the bank individually and the banking group as a whole (e.g., increase in the rate of non-performing loans, decline in the deposit base, decrease in collateral value, deterioration of the bank's credit rating and its resulting increase in funding costs, failure of the largest customer at the level of funding sources or incoming cash flows).

2-3-3-5 External scenarios related to market conditions, assuming that a number of banks, the banking sector, or the entire financial system are affected (e.g., deterioration in funding prices, decline in the credit rating of countries where the bank's activities are concentrated, economic contraction with increasing default cases, lack of interbank market liquidity, or unfavorable changes in interest rates and yield rates).

4-3-5 Tests must include a set of behavioral assumptions for the bank's customers (depositors and borrowers) or other parties to funding sources.

5-3-5 When conducting stress tests for liquidity risk, the bank must use different time frames starting from the next day, up to one year at a minimum. Short-term tests on liquidity positions during a single working day can also be conducted.

6-3-5 The bank may use the expected net cash flow methodology to estimate the degree of impact of liquidity risk within stress tests, by identifying the time period showing the minimum cumulative net cash flows or negative cash flows according to the methodology used.

7-3-5 The bank must use mandatory liquidity ratios (liquidity coverage ratio, net stable funding ratio, and the prescribed minimum for the liquidity ratio) when conducting stress tests.

8-3-5 Emphasize the availability of the following when preparing scenarios for liquidity risk in the stress testing programs report:

1-8-3-5 Policies approved by the Board of Directors including maximum and acceptable liquidity risk levels.

2-8-3-5 Policies approved by the Board of Directors including the ability of the bank's subsidiaries to obtain liquidity and the prescribed limits for that, in accordance with the maximum and acceptable liquidity risk levels of the bank. In case of exceeding prescribed limits, the resulting consequences and how to address those breaches must be presented to the Board of Directors.

4-5 Operational Risk:

Stress tests for operational risk include preparing scenarios to measure high risks the bank may face due to deficiencies arising from failures in internal processes, people, or systems, including IT risks and legal risks, or external events such as cyberattacks, or reliance on outsourcing service providers to perform some of the bank's important activities, in addition to internal or external fraud, which may affect all bank products and activities or its ability to continue providing its products.

5-5 Concentration Risk:

Concentration risk is evaluated within stress tests at the level of exposures to the bank's counterparties (including a single customer, a single customer and its related parties, related parties and their related parties), as well as types of credit facilities, concentration in the credit rating of customers, concentration in maturities, concentration in local and foreign currencies, concentration in deposits, bank products, industries, economic sectors, geographical areas, countries, correspondents, and outsourcing service providers.

6-5 Interest Rate Risk for Non-Trading Positions:

Stress tests for interest rate risk include preparing scenarios to measure risks arising from unfavorable movements in interest rates for retained positions in the market over a specific period, which may negatively affect the bank's profitability and/or the economic value of its equity, and thus its financial position. This risk relates to positions graded in the portfolio for non-trading purposes.

In addition to the aforementioned risks, any other risks deemed important by the bank when conducting stress tests must be considered, such as contagion and rapid spread risks, reputation risk, risks resulting from providing a new product or service, compliance risk, model risk, strategic risk, or climate change risks.

-6 Selection of Scenarios and Methodologies

1-6 Banks must conduct hypothetical scenario tests to cover any changes not included when conducting historical scenario tests. When conducting those tests (whether historical or hypothetical scenarios), the gradation in terms of scenario intensity must be considered, including basic assumptions related to the volume of shocks and correlations between risk factors resulting from those shocks.

2-6 When preparing scenarios, changes in the size of the bank and the complexity of its activities, as well as any other factors, must be considered, in addition to the following:

1-2-6 The bank must conduct stress tests before issuing new products, entering new partnerships, or opening foreign branches, and evaluate risks that may arise to determine potential negative impacts and what may affect the overall risk framework.

2-2-6 The results of those tests must be taken into account to make necessary adjustments to existing stress testing programs.

3-2-6 The Board of Directors must be informed immediately if the assessment mentioned above reveals fundamental risks, to be taken into account when making strategic decisions, especially regarding any potential modification in maximum and acceptable risk levels, and the Central Bank must be notified of those decisions.

3-6 Internal models used for calculating capital requirements - for internal bank purposes - can be used in preparing stress test scenarios. Banks may also design and implement internal models specifically for conducting stress tests, provided these models meet the following requirements:

1-3-6 They must include the fundamental risks the bank is exposed to and correlations between risk factors.

2-3-6 They must be comprehensively and clearly documented in terms of data sources, IT infrastructure, assumptions, inputs and outputs, and reciprocal relationships and correlations between risk factors.

3-3-6 They must be reviewed periodically and independently to ensure that assumptions used are reconsidered in light of unfavorable movements and shocks the bank may face.

-7 Review and Evaluation of Stress Testing Programs

Review and evaluation processes of stress testing programs are essential to support the effectiveness of risk management. Therefore, the Risk Sector, in coordination with the Internal Audit Sector of banks, must do the following:

1-7 Evaluate the efficiency and effectiveness of applying the general framework of stress testing programs periodically, the methodologies used, the intensity of scenarios and applied assumptions, types of risks, and governance systems for stress tests.

2-7 Periodically evaluate and update contingency plans, business continuity plans, and recovery plans in light of stress test results.

3-7 Evaluate the efficiency and effectiveness of stress testing programs quantitatively by evaluating the quality and accuracy of data, as well as scenarios and assumptions used, and qualitatively by evaluating test objectives, governance requirements, systems used in preparing tests, and development methods.

4-7 Update the general framework of stress testing programs and review and re-evaluate those programs periodically at least annually or whenever required, taking into account that some events and market conditions may require an immediate and comprehensive evaluation of stress testing programs during the year. Procedures and processes of review and evaluation must be documented.

5-7 Update stress test scenarios and assumptions and methodologies used by conducting effective market monitoring by reviewing best practices and methods applied related to evaluating potential unfavorable conditions and assessing their impact on the bank.

6-7 Periodically evaluate the effectiveness of corrective actions and their feasibility in light of tests and scenarios conducted.

-8 Governance Requirements Regarding Stress Testing Programs

1-8 Role of the Board of Directors:

The Board of Directors of the bank is responsible for overseeing the effectiveness of the application of stress testing programs through the following:

1-1-8 Ensure the availability of comprehensive stress testing programs covering all types of risks the bank may be exposed to, and ensure their application at the individual bank level and the banking group as a whole.

2-1-8 Approve policies for stress testing programs prepared by the Risk Sector, as well as any significant changes or developments introduced to those programs, ensure compliance with them, and ensure the dissemination of those policies to enhance the risk management culture across the bank.

3-1-8 Ensure the availability of suitable information system infrastructure and qualified human resources to conduct stress tests and prepare related reports.

4-1-8 Coordinate with senior management through the Risk Committee regarding the coverage of all types of risks the bank may be exposed to and the adequacy of the number of scenarios and documented assumptions used.

5-1-8 Determine the acceptable risk level for the bank according to stress test results, which is done through the following:

1-5-1-8 Direct obtaining all necessary information to conduct stress tests.

2-5-1-8 Request regular reports to display the main results shown by stress tests and their impact on the risk level in the bank.

3-5-1-8 Use stress test results as one of the inputs for the strategic decision-making process.

4-5-1-8 Approve and periodically review the risk policy.

6-1-8 Coordinate with senior management to take necessary corrective actions regarding the results of stress testing programs.

2-8 Role of Senior Management:

It is the responsibility of the heads of the Risk Sector in the bank, in coordination with heads of relevant sectors, to prepare and monitor the implementation of stress testing programs as follows:

1-2-8 Review stress testing programs and identify potential scenarios that may affect the bank's activities and business continuity, ensuring they are clear and documented.

2-2-8 Participate in implementing and developing the risk mitigation policy, as well as taking necessary corrective actions in this regard.

3-2-8 Make available important information, data, and reports at the quantitative and qualitative levels in a timely manner to the Board of Directors to support the decision-making process.

4-2-8 Provide suitable information system infrastructure and qualified human resources to conduct stress tests, in addition to necessary training programs to enhance the efficiency of officials responsible for preparing stress tests.

This is with emphasis on the existence of effective and continuous communication between the Board of Directors and senior management regarding stress tests and scenarios and assumptions being evaluated. Reports reflecting quarterly the results of stress tests prepared by senior management must be submitted to the Risk Committee for approval and presentation to the Board of Directors for adoption.

-9 Requirements of the Central Bank of Egypt Regarding Stress Tests

Banks must submit to the Central Bank of Egypt - Off-Site Supervision Sector - the report on the Internal Capital Adequacy Assessment process, including the report on stress testing programs according to the requirements set out in this item. This must be done annually within a maximum period of 90 days from the end of the financial year, starting from the end of the 2024 financial year. The Central Bank of Egypt must be notified of any fundamental changes that may occur during the year in the general framework for stress tests. Banks may also be asked to submit the report on stress testing programs for any other time period specified by the Central Bank whenever deemed necessary. The responsibility for approving the report lies with the Board of Directors of the bank. In the case of branches of foreign banks operating in Egypt, it must be approved by the Regional Manager, subject to the following minimum requirements:

1-9 Data

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