Stress testing methodologies in risk management and their role in banking regulations

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Supervisor:
Dr. Kósa Zsuzsanna Mária
Department of Telecommunications and Media Informatics

The financial crisis of 2008 was a perfect example that banks could be affected by shocks manifesting in adverse market shifts, causing the loss of their capital, bankruptcy and resulting in governmental intervention in order to save them. This caused that supervisory organizations have formulated more rigorous requirements in Basel II regulation 2nd pillar with regards to the capital accumulation methodologies involving an augmented attention to various stress tests. In this thesis I present the implementation of a simulation procedure that is able to accelerate the exploration of the interest rate risk lying in banking books.

In this study I introduce how a bank balance sheet is built, how banks work and therefore what type of risks are they exposed to due to the operation, paying special attention to interest rate risk in banking book. I demonstrate the economic value based (EVE) and the net interest income based (NII) calculation methodology and the role of stress testing in risk management. I defined 6 different stress scenarios according to Basel II regulation to examine the effect of the interest rate curve changes on the banking book with a self-developed application. The implemented stress scenarios are the following: 200 basis points parallel up and down rates shift, short and long rates shocks and steepener and flattener rates shock.

I created the data set, the hypothetical balance sheet by myself, which serves the base of the Economic Value of Equity calculations. I designed and created a database for the hypothetical balance sheet which I set up in Microsoft SQL Server. I used MATLAB for the development of the stress testing application; I’m discussing in detail the steps of the implementation in my thesis starting from the design of the process steps through the visualisation to the implementation of the graphical user interface. To verify the calculations of the program I made a detailed financial analysis with great emphasis to the interpretation and evaluation of the results.

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