One way of stress testing credit risk under the Internal Capital Adequacy and Assessment Process (ICAAP) is to consider percentage falls in the Forced Sale Value (FSV) of mortgaged collateral which is discussed below.
Fall in FSV of mortgaged collateral:
In this case the impact of a 10%, 20% and 40% decline in the Forced Sale Value would be analyzed. The tax-adjusted impact of the additional required provision will be calibrated in the CAR for each of the scenario.
- Weighted FSV of Collateral = FSV for sub standard category * 25%(Provision required for sub standard category) + FSV for doubtful category * 50%(Provision required for doubtful category) + FSV for loss category* 100%(Provision required for loss category)
- Fall in the FSV Collateral = Weighted FSV of Collateral * 10% (fall in FSV)
- Tax Adjusted Loss = Fall in the FSV Collateral * (1 – Tax Rate)
- Revised Capital = Original Capital – Tax Adjusted Loss
- Revised risk weighted assets = Original risk weighted assets – Tax Adjusted Loss
- Revised CAR = Revised Capital / Revised risk weighted assets
- Fall in CAR (% age points) = Original CAR – Revised CAR
We have reviewed a simple sensitivity analysis of credit risk by assuming that the Forced Sale Value (FSV) of mortgaged collateral falls by certain percentages. In the coming posts we will be considering two other credit risk stress tests, the transition matrix stress test and the profitability analysis stress test. However in order to perform these stress tests it is first important to understand how transition matrices are constructed, expected classification rates are derived and profitability analysis is carried out. These will be covered in the following three posts.
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