With a view to strengthening the banking sector, the Reserve Bank of India has asked the banks to formulate 'stress tests' as part of the risk management exercise to guard against possible danger to their solvency.
"Banks shall put in place appropriate stress test policies and the relevant stress test framework for the various risk factors by September 30," the RBI said in a communication to heads of commercial banks on Tuesday.
The formal stress testing mechanism will come into operation from March 31, 2008, it added. The stress tests to be designed by each bank will help them in taking remedial action against possible risks like sudden economic downturn, interest rate fluctuation, foreign exchange rates, collapse of communication system, natural disasters, stock market crash, depletion of country's foreign exchange reserves, et cetera.
The remedial actions that banks may undertake pursuant to findings of the stress tests, include reduction of risk limits, enhancing collateral requirements, amendments to pricing policies, augmenting capital and increasing sources of funding.
The banks, as per the central bank guidelines, will be required to conduct stress tests for volatile risks on daily or weekly basis, for less volatile risks on monthly or quarterly basis, and ad hoc tests for extraordinary risks like rapidly deteriorating political and economic conditions.
The banks have also been asked to undertake stress tests on trial basis before firming up the formal stress testing mechanism.