rams a test for sub prime, page-18

but at least the amount of funding reqd under basel mk II can be stressed tested to a specific lenders credit risk, unlike the current scenario which has a blanket one size fits all approach. As with any modeling the detailed assumptions used in the valuation model are crucial but the stress testing will be based on multiple scenarios. The current requirements are really just rules of thumb that seem to have worked okay in the past - this system promises to be much more rigorous if the stress testing is conservative enough.

Basel is not my area of expertise but someone very up to speed with it emailed me this last week which sums it up nicely:


"In fact, the literature makes it abundantly clear that multiple scenarios, of varying likeliness, are required to constitute an effective stress test and that these tests and scenarios need to be re-run and re-evaluated on a regular basis to accommodate both changes in the Bank’s asset mix and in future expectations.

Interestingly, some of the literature suggests that, not only should expected or likely scenarios be tested, but some unusual or unexpected scenarios should also be tested to gauge their likely effects. This would involve four possibilities:

1. Simulating shocks which we suspect are more likely to occur than historical observation suggests;
2. Simulating shocks that have never occurred;
3. Simulating shocks that reflect the possibility that statistical patterns could break down in some circumstances; and
4. Simulating shocks that reflect some kind of structural break that could occur in the future.

A Possible Stress Testing Regime:

An effective, rigorous and forward looking stress-testing regime would therefore include multiple likely scenarios - including examining movements in all the major macro-economic variables over the past 10 to 20 years and an examination of their likelihood. Capital should be held to allow for these types of events and, in the event that they occur, the minimum capital to be held, as mandated by the regulators, should be allowed to fall to the predicted level. The bank should also have plans to re-establish appropriate levels of capital during the recovery phase from the stress event, with the understanding that other banks in the market will also be attempting similar strategies.

Stress-testing should also include unlikely, but possible, events, along the lines of the four points above. As an example of each one, stress tests could involve such things as the effects of:

1. Asian Crisis (1997 – 1998)
2. Russian Debt Default
3. US Terrorist Attacks
4. Hostilities in Iraq in 2003-04

None of these scenarios may be statistically likely to reoccur, but scenarios similar to these would form a part of a rigorous and forward-looking stress-testing regime. In the event that these scenarios show a possible capital or liquidity deficiency, a bank should have a plan to address the scenario and should be prepared to present and discuss these plans with the regulators."



Basel wont mean banks will HAVE to lower their capital reserves - it is notable that ANZ already holds significantly more in term deposits than required for its lending, notwithstanding it has been cheaper to use short term debt, and will benefit if the credit crunch continues. There will always be a role for the conservative John McFarlane types as well as those arbitrageur risk tolerant Nicholas Moore types.

Probably should go back to talking about shorn rams on this forum though.. lol