Instructions for Stress Testing (No. 2016/1)

15779/2/23 H
06/03/1438 H
06/12/2016 M

Instructions for Stress Testing for Banks in Jordan (No. 2016/1)

Based on the provisions of Article 9/b of the Central Bank of Jordan Law No. 28 of 2000 and its amendments.

Table of Contents

2. Introduction
3. First: Objectives of Stress Testing
4. Second: Stress Testing Governance
5. Third: Design of Stress Testing
6. Fourth: Procedures the Central Bank Will Take
7. Fifth: Review and Frequency of Stress Testing
8. Sixth: General Provisions

Introduction

Stress testing is an important tool used by banks to measure their resilience. These tests aim to assess the bank's financial position against high risks and shocks it may face. They are also considered tests of the bank's conditions during crises, surpassing statistical methods based on historical information by using severe but possible scenarios. These tests help the Board of Directors and senior management understand the bank's conditions during crises. They are considered a fundamental part of the risk management process, not only because they can include risks alone, but also because they work within an integrated risk management policy to strengthen the bank's weaknesses as a whole and reinforce the financial system.

The Central Bank of Jordan may have issued Instructions for Stress Testing No. 2009/46. This subject has witnessed important developments since then, especially after the financial crisis on 30/9/2009. The Basel Committee on Banking Supervision issued its 2009 Key Principles for Stress Testing in 2009. In 2012, the Committee also issued a paper on reviewing the application of stress testing principles. In addition, the International Monetary Fund undertook to develop comprehensive methodologies for supervisory authorities to implement these tests. Supervisory authorities in various countries around the world have become focused on these tests. The issuance of these instructions by the Central Bank comes in light of these developments, taking into account the need to apply those principles, in order to keep pace with the latest developments in this subject and align with best global practices.

First: Objectives of Stress Testing

Stress testing is used to achieve the following objectives:

1. Identification of Key Risks and Control: Stress testing is considered a fundamental part of risk management operations at the bank, aiming to identify risks faced at different levels. These tests focus on these risks and their potential impacts, serving as a key quantitative tool to assess the bank's ability to face different types of shocks. They help understand the risk profile (Risk Profile) of the bank.

2. Assistance in Capital Planning Process: Stress testing forms an important part of the capital planning process. These tests provide tools to assess the adequacy of the bank's internal capital during the Internal Capital Adequacy Assessment Process (ICAAP) to face all risks with impact. These tests also help the bank estimate the amount of future capital it must have during the coming years to face any potential financial shocks.

3. Assistance in Liquidity Management: Stress testing forms an important part of liquidity management. These tests assess the bank's liquidity and the adequacy and sufficiency of liquidity mitigants, thereby measuring and controlling liquidity risks. They are considered a complementary tool to other risk management tools such as Value at Risk (VaR), which are based on historical data and do not represent an alternative to statistical relationships.

4. Provision of Detailed Data on the Bank's Exposure to Risk Factors: This includes providing a comprehensive analysis of weaknesses in the bank.

5. Enhancing Public Confidence in the Stability of the Banking Sector: This is achieved by publishing stress test results to reassure citizens that the total level of the banking sector is capable of withstanding high risks and shocks.

Second: Stress Testing Governance

1. Stress testing must form an essential part of risk governance (Governance Risk). This enhances the bank's ability to identify and manage risks, including credit risk management, investment portfolio management, and risk management related to specific activities in the bank. The results of the tests should be used in decision-making at the administrative level, including strategic decisions by the Board of Directors and senior management.

2. Role of the Board of Directors and Senior Management:

   a. Role of the Board of Directors:

   • The Board is responsible for ensuring the existence of an effective framework for stress testing to assess the bank's ability to withstand shocks and high risks.
   • The Board must ensure that the Risk Management Department conducts stress tests periodically, playing a key role in adopting assumptions and scenarios used, analyzing results, and approving procedures to be taken based on these results.

   b. Role of Senior Management:

   • Monitor the implementation of the stress testing program in accordance with the approved methodology.
   • Ensure the availability of qualified staff in the Risk Management Department to conduct stress tests, possessing appropriate tools and means.
   • Ensure the availability of a suitable number of potential scenarios related to the bank's operations, with these scenarios being documented and understandable.
   • Use stress test results in determining the degree of risk tolerance and in capital and liquidity planning processes (Risk Appetite Statement).

3. Internal Policies and Procedures and Documentation:
   Internal policies and procedures governing stress testing must be approved by the Board of Directors and documented in an appropriate manner, including:
   a. Details of stress tests, including type, objectives, scenarios used, and types of tests for each type. b. Reasons for selecting tests, including the role and opinion of experts in the bank.
   c. Evaluation of basic assumptions built on tests at least annually, or in light of changing external circumstances, documenting the results of the evaluation process.
   d. Periodic implementation of stress tests within the bank, varying in type and objective. e. Details of methodologies used in determining scenarios, calculations, and operations used to calculate results. f. Corrective procedures to be taken based on the type and objective of tests and results, assessing the effectiveness of these procedures in the event of stress.

   Footnote 1: For branches of foreign banks operating in the Kingdom, internal policies and procedures are subject to the approval of the Regional Manager.

4. Appropriate Infrastructure:
   The bank must have appropriate infrastructure to assist in conducting stress tests, including:
   a. A sufficient database of qualified staff, accurate and comprehensive data, and appropriate management information systems (MIS), dedicating sufficient resources. The bank must maintain and develop this infrastructure to enable updating methodologies periodically and applying new scenarios as needed. The infrastructure must be flexible enough to allow conducting stress tests at the overall bank level or at the level of a specific activity. b. Information systems used by the bank must be commensurate with the bank's size, nature, complexity, and risk structure.
   c. An appropriate mechanism must be available at the bank to provide periodic reports on test results to senior management and the Board of Directors in a timely manner.
   d. Although the design and implementation of stress tests may be considered an internal process, the bank may resort to outsourcing some operations (Outsourcing). In this case, the bank must ensure the validity of methodologies by reviewing them, ensure that required activities are performed in a clear and documented manner by sources capable of understanding and evaluating the results of their work, and ensure that all work performed by external sources falls within the overall risk management framework at the bank. Additionally, the bank must take procedures to maintain compliance with applicable laws and regulations, including banking secrecy.

Third: Design of Stress Testing

1. The design of the stress testing program, including models, methodologies, and tools, requires cooperation among various experts in the field to benefit the bank from results. The Risk Management Department should organize appropriate dialogue between different parties to take into account their views on potential stress shocks, scenarios, and risks compatible with internal and external risks. All relevant parties in the bank should participate in this dialogue, such as risk management officers, economists, heads of research and studies departments, and treasury facilities departments.

2. The stress testing program should include both qualitative and quantitative methods to improve the comprehensiveness of these tests. Tests should range from simple sensitivity tests based on changes in one risk factor to statistical methods based on scenarios taking into account relationships between systemic risk drivers. These methods should surpass historical data-based approaches.

3. Banks should consider two types of tests within the stress testing program: Sensitivity Analysis tests and Scenario Analysis tests.

   a. Sensitivity Analysis Tests:

   • These tests are used to measure the impact of movements in risk factors on the bank's financial position, such as changes in interest rates, exchange rates, stock prices, or increases in non-performing loans. Usually, the source of the shock is not identified in these tests. They aim to assess the bank's sensitivity to one risk factor, considering interactions between different risk factors.
   • The bank must identify risk drivers (Risk Drivers) that may affect it, such as macroeconomic variables (e.g., interest rates), credit-related risks (e.g., increases in non-performing loans or exchange rates), financial market volatility (e.g., stock price fluctuations), operational risks (e.g., fraud, natural disasters, system failure), etc.
   • The bank must conduct sensitivity analysis tests at various levels of intensity, based on historical data and supported by reasonable assumptions at the economy or bank level, drawing on past experiences.
   • The bank should conduct sensitivity analysis tests at multiple levels within the bank, such as individual exposures, portfolio level, business line level, or overall bank level.
   • Banks must conduct sensitivity analysis tests covering credit risk, market risk, liquidity risk, and operational risk, including concentration risk.
   • The Central Bank will provide banks annually with sensitivity analysis tests to conduct, considering local, regional, and international risk developments. Banks may include new tests at different intensity levels compared to previous tests, or fully or partially change tests if there are significant financial or economic developments.

   b. Scenario Analysis Tests:

   • These tests work to assess the impact of scenarios that may have a low probability of occurrence but a significant impact on the bank's financial position if they occur.
   • This type of tests includes:
     1. Historical tests: Based on historical events that occurred in Jordan or other countries (e.g., the 1988-1989 Dinar crisis, the global financial crisis).
     2. Hypothetical tests: Assumed possible events (e.g., sharp decrease in GDP growth rate, increase in unemployment, decrease/increase in interest rates).
   • Hypothetical tests generally involve fundamental changes in economic variables, which may have negative effects on the bank's conditions, such as increased non-performing loan ratios, decreased profitability affecting adequacy, and factors sharply affecting liquidity.
   • Key macroeconomic variables to consider in building hypothetical tests include:
     a. Decrease in GDP growth rate (e.g., stock prices decrease by 40%, 60%, 90%, or interest rates change by 100, 200, 300 basis points). b. Increase in unemployment levels.
     c. Decrease/increase in inflation rates.
     d. Decrease/increase in interest rates. e. Decrease in stock prices. f. Decrease/increase in oil prices in global markets.
   • The Central Bank will provide banks annually with scenario analysis tests to conduct, considering local, regional, and international risk developments. Banks may include new tests at different intensity levels or fully/partially change tests if there are significant financial or economic developments.

Fourth: Procedures the Central Bank Will Take

1. If test results indicate a weakness in the bank's liquidity or capital, the Central Bank will request the bank to provide the procedures it intends to take to enhance liquidity or capital.

2. The procedures the bank intends to take must be commensurate with the stress test results, the intensity of the tests' impact, the general risk management framework, and the bank's hedging policies.

3. If the Central Bank is not convinced of the adequacy of the procedures the bank intends to take, it may impose restrictions on the bank's capital or liquidity distribution to enhance the bank's capital or liquidity.

Fifth: Review and Frequency of Stress Testing

The Internal Audit Department is responsible for reviewing and evaluating the stress testing framework, raising evaluation and review results to the Board of Directors at least annually. The review process includes:

1. Determining the efficiency and effectiveness of the bank's operational framework for stress testing, covering any need to modify any part of it, including:
   a. The extent of the program's efficiency in achieving its objectives. b. The assumptions used in building stress tests.
   c. The realism of the tests applied.
   d. The applications of systems used in preparing tests. e. Management supervision. f. The quality of data and information systems. g. Documentation.

2. Ensuring that procedures for updating stress testing methodologies are documented and implemented clearly.

3. Evaluating the accuracy of data and the validity of calculations in stress tests, including the models used.

Sixth: General Provisions

The bank must consider the following at least:

1. Stress tests should include scenarios ranging from least to most impactful. The purpose is to determine the bank's ability to continue and the impact of those scenarios, considering the level of coverage and identifying latent risks not covered. This includes assessing the potential impact on the bank's financial position through expected loss volume or otherwise, and on the bank's reputation.

2. The results of stress tests should be used in developing contingency plans to deal with risks, activating and using various risk mitigation tools such as hedging and netting within the budget. The effectiveness of using these tools during difficult economic and financial conditions must be evaluated at the same time, along with guarantees.

3. Develop methodologies to measure the impact of reputation risk, expressed through other risks such as credit and market risks. This involves including stress tests for certain scenarios related to liquidity and reputation risks.

4. The results of stress tests should be used to identify, monitor, and control concentration risk. The selected scenarios must correctly reflect the bank's exposure to concentration risk at the overall bank level, covering certain business lines, internal and external assets, and considering potential changes in market conditions that may negatively affect the bank's concentration risk.

5. Stress tests must cover all complex financial products as needed. This represents the banks' commitment to estimating risks of financial products, which occurred during the last financial crisis to avoid it. Relying only on historical data or external credit ratings is insufficient and inadequate methods for all risks associated with complex financial products, especially in severe crisis situations.

6. Stress tests must include scenarios assessing the volume and impact of off-balance sheet items and other risks, especially credit, market, and liquidity risks, on the bank's capital adequacy and liquidity.

7. The Central Bank will evaluate the framework within which banks conduct stress tests comprehensively and regularly to ensure compliance with the standards contained in these instructions, especially regarding the role of the Board of Directors and senior management in integrating these tests into risk governance and risk management operations, and the extent of using results in decision-making at various administrative levels in the bank, with the aim of enhancing risk management and activation in banks.

8. The Central Bank will evaluate banks' compliance with best practices in the field of stress testing, including instructions issued by external supervisory authorities regarding stress tests, in the presence of external entities.

9. The tests used must be commensurate with the bank's defined risk appetite (Risk Appetite), such that the selected scenarios are commensurate with the bank itself, its defined limits, associated risks, and the complexity, nature, and volume of its operations.

10. The Central Bank will request banks to conduct stress tests for products at least once to assess weaknesses in the overall financial system or specific financial products through test application.

11. Banks must take into account the results of stress tests in developing recovery plans. These plans are considered part of the business continuity plan, helping the bank continue as an important tool whether the risks are internal or external, working to reduce the impact of negative events on it.

12. These instructions are effective as of the date of their repeal, replacing everything contrary to them.

The Governor
Dr. Ziyad Al-Fariz