One forward looking aspect of the Internal Capital Adequacy and Assessment Process (ICAAP) is the stress testing of all risk factors in order to arrive at the capital requirements for the worst case scenario. Stress testing also allows the bank to plan and prepare for unexpected situations that may arise in the future. In this and the following two posts we will look at some of the stress tests applied for credit risk. In later posts we will consider stress tests for Market and Liquidity Risks. In this post we look at the NPL stress test assuming that the classified portfolio continues to deteriorate until all classified loans fall into the subcategory of “Loss”, indicating that the outstanding amount will never be recovered.

# Stress Testing

## Credit Risk

### Non-performing loan (NPL) stress test

The rationale behind the NPL stress test is to calculate and track the amount of capital required in the event of a continuous downgrade in the non performing portfolio. Tracking and reporting this amount of capital will provide the necessary incentive to keep classification in check and will allow management to respond and take corrective action if this number exceeds a certain level or remains over a threshold for a certain amount of time.

The NPL stress test involves studying the impact of a continuous deterioration in the non-performing portfolio. This is an extreme case stress test which assumes that no recovery is possible, no repayment will take place, and no accounts will be restructured and it computes the resulting provision requirements.

The NPL stress test is used together with the transition matrix and resultant expected classification to calculate the worst case provisions and hence the worst case earnings for the profitability analysis.

This exercise consists of the following steps:

- For all non performing facilities, generate a list of customers with outstanding exposure net of eligible collateral.
- Determine existing classification for each facility.
- Calculate provision requirement (%).
- Calculate provision required based on outstanding exposure after accounting for eligible collateral.
- This becomes the existing provisioning requirement on the revaluation date.
- Calculate days past due (DPD) for the revaluation date.
- Calculate revised days past due for the next four quarters assuming no recovery.
- Calculate revised classification for the next four quarters.
- Calculate revised provisioning requirement (%) for the next four quarters
- Calculate provision required for the next four quarters.
- If at the end of the fourth quarter, all facilities are not classified as loss, additional quarters will be added. This is a function of the definition of loss. The objective is to estimate when the institution will take a hit if a continuous downgrade of the non performing portfolio were to take place.
- The provisioning requirement is then consolidated at an industry level for each quarter.
- Calculate total provision required for each quarter.
- Calculate incremental provision required for each quarter.

The Incremental provision over the existing provision amount **is** the additional amount of capital that will be required to support the downgrade in the event that this scenario would take place.

In the post we have reviewed the NPL stress test. In the next post we will discuss two techniques of carrying out a simple sensitivity analysis, firstly by increasing the NPL by a certain percentage and secondly by shifting the NPLs from one classified category to another lower classified category by a certain percentage.