The Basel Committee on Banking Supervision issued a consultation paper that sets out principles for beefed up stress testing practices at banks.

The paper presents sound principles for the governance, design and implementation of stress testing programs at banks. It aims to address weaknesses in stress testing that were exposed by the financial crisis. “These include the underestimation of the potential severity and duration of stress events and the insufficient identification and aggregation of risks on a firm-wide basis,” it notes.

The paper also sets expectations for the role and responsibilities of supervisors in reviewing firms’ stress testing practices and emphasizes elements that a sound stress testing program should include.

Nout Wellink, chairman of the Basel Committee and president of the Netherlands Bank, noted that “stress testing is an important risk management tool. It plays a critical role in strengthening not only bank corporate governance but also the resilience of individual banks and the financial system”. He added that “the financial crisis has demonstrated the importance of stress testing as an integral part of any bank’s risk management, liquidity and capital planning process”.

The BIS says that the paper comes in response to the G20 summit on financial markets held back on November 15, 2008. Comments on the paper are due by March 13.