Taking Control – Managing the Pain Points in Stress Testing

Taking Control – Managing the Pain Points in Stress Testing

Introduction

The depth and duration of the financial crisis has led many banks and supervisory authorities to question whether stress testing practices were sufficient prior to the crisis and whether they were adequate to cope with rapidly changing market conditions. In
particular, not only was the crisis far more severe in many respects than was indicated by banks' stress testing results, but it was possibly compounded by weaknesses in stress testing practices in reaction to the unfolding events. As the crisis comes to an end, there are already lessons for all market participants emerging from this episode.

Stress testing is an important risk management tool that is used by banks as part of their internal risk management and, through the Basel II capital adequacy framework, is promoted by supervisors. Stress testing alerts bank management to adverse unexpected outcomes related to a variety of risks and provides an indication of how much capital might be needed to absorb losses should large shocks occur. While stress tests provide an indication of the appropriate level of capital necessary to endure deteriorating economic conditions, a bank alternatively may employ other actions in order to help mitigate increasing levels of risk. Stress testing is a tool that supplements other risk management approaches and measures. It plays a particularly important role in:

• Providing forward-looking assessments of risk
• Overcoming limitations of models and historical data
• Supporting internal and external communication
• Feeding into capital and liquidity planning procedures
• Informing the setting of a banks’ risk tolerance
• Facilitating the development of risk mitigation or contingency plans across a
range of stressed conditions

Stress testing is especially important after long periods of benign economic and financial conditions, when fading memory of negative conditions can lead to complacency and the underpricing of risk. It is also a key risk management tool during periods of expansion, when innovation leads to new products that grow rapidly and for which limited or no loss data is available.

Pillar 1 (minimum capital requirements) of the Basel II framework requires banks using the Internal Models Approach to determine market risk capital to have in place a rigorous programme of stress testing. Similarly, banks using the advanced and foundation internal ratings-based (IRB) approaches for credit risk are required to conduct credit risk stress tests to assess the robustness of their internal capital assessments and the capital cushions above the regulatory minimum. Basel II also requires that, at a minimum, banks subject their credit portfolios in the banking book to stress tests. Lepus research has indicated that banks’ stress tests did not produce large loss numbers in relation to their capital buffers going into the crisis or their actual loss experience. Furthermore, banks’ firm-wide stress tests should have included more severe scenarios than the ones used in
order to produce results more in line with the actual stresses that were observed.

A stress test is commonly described as the evaluation of a bank’s financial position under a severe but plausible scenario to assist in decision making within the bank. The term ‘stress testing’ is also used to refer not only to the mechanics of applying specific individual tests, but also to the wider environment within which the tests are developed, evaluated and used within the decision-making process. In this paper, the term ‘stress testing’ will be used in this wider sense. Finally, this paper, with the aid of secondary research and interviews with leading banks, will explore in further depth four key areas within stress testing, namely:

• FSA’s new liquidity regime
• Data
• Benchmarking and frameworks
• Reporting and transparency
• Business benefits

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