Stress Test Of Commercial Banks On Retail Mortgages

Since the subprime crisis, stress testing as a financial institutions risk management tool was promoted to a new height, receiving unprecedented attention. Stress testing is indeed required by the Basel Committee as one of seven conditions to be satisfied to use internal models. It is also endorsed by the Derivatives Policy Group and by the Group of Thirty. Stress testing can be described as a process to identify and manage situations that could cause extraordinary losses.The article describes the origins, characteristics, and history of stress testing. It provides some background on the creation of stress testing and value-at-risk. The study also assesses the merits and shortcomings of them.The main purpose of value-at-risk measure is to quantify potential losses under "normal" market conditions, where normal is defined by the confidence level, typically 99 percent. In principle, increasing the confidence level could uncover progressively larger but less likely losses. In practice, value-at-risk measures based on recent historical data can fail to identify extreme unusual situations that could cause severe losses. This is why value-at-risk methods should be supplemented by a regular program of stress testing. Stress testing is a nonstatistical risk measure because it is not associated with a probability statement like value-at-risk.This study, using real life retail mortgages from a China commercial bank, tries to build an effective framework of stress testing based on the basic theory of stress testing and existing domestic and international stress testing approaches.