Stress Testing Methodologies for Islamic Finance

Abstract

This Chapter discusses a curtail requirement for preparing the various regulatory documents we discussed in earlier chapters of this book (Chaps. 11 and 12). Stress testing and reverse stress testing should be incorporated in capital and liquidity assessments as an integral component, and should include EWIs (early warning indicators) and ongoing monitoring by the management of IFIs (Islamic financial institutions) to identify any threats as early as possible. In this context, I highlight the importance of stress testing as a risk management tool for IFIs, I also discuss macro and micro stress testing, the implication of stress testing to IFIs and particular consideration in stress testing and reverse stress testing for IFIs. The analysis provided here outlines a blue-print template for stress testing and reverse stress testing for a resilient financial system that would act as a guide for the Islamic finance industry. It will help all Islamic financial institutions tailor their stress testing scenarios for any financial, market or liquidity shocks or capital and liquidity requirements to reflect their Shariah governance and specific operational model, while still complying with applicable capital adequacy and liquidity regulations.