Basel Committee s recommendation to banks regarding stress testing practices: (1) Governance.

Stress testing should be integrated into governance and risk management functions of bank even at board and senior management levels. (2) Multiple Uses of Stress Tests. Bank should be mindful that stress tests have multiple uses, including risk identification and control, complementing other risk management tools (e.g., economic capital and VaR) by providing new perspectives and even testing those other tools, assist in internal assessment of capital adequacy and liquidity needs, and facilitation of internal and external communication. (3) Multiple Perspectives Required. Stress testing must involve risk controllers, economists, business managers, and traders. The unit conducting stress testing should facilitate dialogue with and among these firm constituencies, including by questioning their perspectives when appropriate. (4) Documentation. Stress testing program should be governed by internal policies and procedures, which should be documented. The choices of the stress test parameters and methodologies should be documented as well. By so doing, a bank can benchmark its stress tests results. (5) Robust, Flexible Infrastructure. Bank should be able to quickly aggregate its exposures to risk factors and modify methodologies to apply new scenarios as needed. Infrastructure should be flexible enough to accommodate ad hoc stress tests during times of stress. (6) Regular Updating and Assessment. Banks should review stress test results and methodologies to evaluate the involvement of senior management and board, the appropriateness of assumptions, the effectiveness of documentation, and the overall effectiveness of the tests in enhancing the firm s awareness of its risk exposures. Because stress testing relies on human judgment, independent controls (audit, non-stress testing risk management personnel) must play a key role in the process. (7) Comprehensive View of Firm. Banks should conduct firm-wide stress tests. The stress tests themselves should gauge how scenarios affect a wide range of important business metrics, including: asset values, p-and-l, regulatory capital, economic capital, and liquidity/funding. In order to challenge the business model (and be useful) and support decision making, scenarios must assess nature of inter-linkages among portfolios, units, products, and entities, as well as across time. (8) Wide Range of Scenarios. Stress tests should include imaginative scenarios across a wide spectrum of events of varying severity levels. The tests should also cover forward-looking scenarios to incorporate changing business realities. By so doing, stress testing can stimulate discussion at different levels in the bank. The role of human judgment is critical, since in areas

characterized by high uncertainty the effectiveness of stress testing depends on exercise of imagination. (9) Mindfulness of Failure. Banks should conduct reverse stress tests which inquire into which events could cause a bank to fail. Moreover, these reverse stress tests should consider scenarios beyond normal business settings with contagion and systemic implications. Reverse stress tests will be most useful with respect to business lines for which there is little reliable data (e.g., new products, exceptional good risk-return trade-offs, exposures without liquid two-way markets) on which more quantitative approaches may be based. (10)Funding-Assets Linkages. Because funding and asset markets are strongly correlated during times of stress, an effective stress testing program will explore these connections. (11)Challenge Risk Mitigation Techniques. Performance of risk mitigation techniques e.g., hedging, netting, collateral should be challenged and assessed systematically under stressed conditions when markets are not functioning and multiple institutions simultaneously could be pursuing similar strategies. (12)Complex Products. Though it will be more difficult, banks must engage in detailed examination of risks of complex products such as CDOs rather than rely on external ratings. (13)Pipeline and Warehouse Risks. Any comprehensive stress tests must take account of a bank s exposures to pipeline and warehouse risks. (14)Reputational Risk. Bank should develop methodologies to measure the effect of reputational risk (e.g., bringing off-balance sheet exposures onto the balance sheet in absence of contractual obligations) on other risk types. (15)Leveraged Counterparties. In cases of severe market shocks, exposures to hedge funds, investment banks, financial guarantors, derivatives counterparties, even if collateralized, may increase sharply. Stress tests should capture correlations between counterparties.

Basel Committee s recommendation to regulators regarding stress testing practices: (1) Regular Assessment. Regulators should make regular assessments of banks compliance with stress testing best practices, and verify management and board-level involvement with stress testing. Regulators should also evaluate the continued relevance of the assumptions driving stress test results. (2) Require Corrective Action. When regulators assessment of stress tests reveals material shortcomings, regulators should require risk-sensitive corrective action. (3) Readiness to Challenge Scope and Severity of Tests. Regulators should question bank methodologies when the impact of stress tests seem unrealistically low or when mitigating actions are unrealistic. Regulators should ensure that the scenarios chosen by bank are appropriate given the bank s risk profile and business mix and include (i) a sustained severe downturn and (ii), where appropriate, a significant episode of financial market turbulence or a market liquidity shock. Regulators should be ready to require banks to conduct reverse stress tests with respect to specific significant business lines. (4) Pillar 2 Capital and Liquidity. (5) Implementation of Industry-Wide, Common Scenario Tests. (6) Cross-Jurisdictional Regulatory Dialogue.