Stress testing bank securities portfolio

Abstract

The purpose of this dissertation is to construct a univariate stress testing model for a securities portfolio of a bank in order to quantify the effects of hypothetical single factor shocks on the capital adequacy requirements. The model focuses exclusively on market and credit risks and relates their impact to the CAR. The significance of better understanding of potential vulnerabilities in the financial system and the measures to assess these vulnerabilities for both the regulators and the managers cannot be over emphasized due to increasing volatilities in the financial markets. Stress testing has been a part of the risk management toolkit for decades, however the interest was largely renewed due to the financial crisis of 2007-2010, which illustrated with painful clarity the inherent limitations of purely statistical models, such as Value at Risk. As a result, stress tests have become an integral tool for banks' risk management practices as well as for financial stability assessments by central banks. In the light of this dissertation, various stress testing models are discussed together with their benefits and shortcomings and exceptional importance is given to stress testing securities portfolio of a bank with the use of single factor shocks. This study therefore provides a basic framework and toolkit for conducting simplified univariate stress tests. Moreover, the dissertation also emphasizes the growing importance of stress tests in the regulatory framework requirements. Needles to say, constituents of securities portfolio of a bank is a highly confidential data and is not available to the general public. Therefore, due to data constraints, a hypothetical securities portfolio of a non-existing Jona bank was constructed, whose composition is intended to mimic the distribution of assets and risk exposures of a typical local bank. The research carried out in this dissertation indicates that in line with a priori expectations, a negative shock to the bank's securities portfolio results in a lower CAR.