Take the stress out of stress testing

Stress testing and its importance for banks

Stress testing is a given for banks, as regulations and compliance pressures loom. Immature stress testing can cause regulatory scrutiny of accuracy and processes. Also, banks incur costs for missed opportunities and wasted resources through laborious, manual operations that fail to reap data for other business initiatives. 

Troy Haines, Senior Vice President for Risk Research and Quantitative Solutions at SAS, discusses the requirements for regulatory stress testing in the US and how the main components of stress testing must be jointly developed and applied by risk and finance teams for greater efficiency and better decision making.

This means that, performed well, active risk management will actually help to manage regulatory risk.

Ray O’Brien
Global Risk COO, HSBC

How has stress testing evolved over the past four to five years?

Troy Haines: Initially, regulators emphasized credit losses and revenue by stressing a few macroeconomic risk factors—as was the focus of SCAP in the US in 2009-10. Today, regulators around the world are not only interested in stress scenario effects on credit performance and revenue, but also the stressed results on a broader array of measures such as liquidity and full balance sheet projections. In other words, stress testing must now be an integral part of the bank’s capital plan, requiring a firmwide approach, which has proved quite challenging. Stress testing has become a systematic way to examine and identify an institution’s financial vulnerability, and regulators have turned it into a process that needs to be transparent, auditable and clearly documented.

The regulators prescribe the scenarios, but not the stress testing process. Are banks on their own?

Haines: Not at all. We see, through stated CCAR principles, that the structured stress testing process has at least six components with a clear need for technology to perform each.

First, banks need a firmwide scenario management process that includes the technology to generate scenarios and make them repeatable from cycle to cycle.

Second, the need for model and model risk management is rather clear. Managing a multitude of models and the risks inherent in them is an enormous task. Banks need a model management platform that can manage all models from scenario models to calculations models.

Third, stress test calculations, because they entail so many differing elements across different scenarios along sometimes disparate systems that are nearly impossible to make on a manual basis, particularly for the diversified bank, require speedy, accurate and automated results.

Fourth, the sheer number of forecasting parameters for financial statement projections makes technology not just a convenience for process governance personnel; it is an imperative.

Fifth, results of each scenario must be aggregated to get a clear picture of what the bank’s financial statements will do under stress.

Finally, banks need to be confident in calculating their capital and leverage ratios. In other words, they need a process to compute required capital, compare it to available capital, then determine if any action is required.

With all of the different regulations requiring stress testing, are there any common themes across the different regimes?

Haines: Yes. The common themes across regulations include the similarity in the stress testing process, the adherence to sound data management principles, the need to integrate both risk and financial measures into stress scenarios when creating the capital plan, and the shift to stressing the full balance sheet and income statement rather than just single portfolios. Regulators prescribe macroeconomic scenarios, and banks must have a structured stress testing process in place to simulate them. Regulators also require banks to comply with balance sheet ratios under stress that are complementary to the existing risk-based capital charges.

Is the current focus of regulators on firmwide stress testing a trend toward replacing risk-based model charges with stress scenarios and, ultimately, a sign of distrust in models?

Haines: That’s a fair argument. However, one can also view the firmwide stress testing as complementary to risk-based models. In practice, the stress testing exercise has developed into a regulatory test of risk models. There is increased regulatory scrutiny on the entire model life cycle—from model development to validation to implementation. Common across most regulatory stress testing regimes, this forces banks to quantitatively project assets, liabilities, income, losses and capital across a range of macroeconomic scenarios. Model complexity and portfolio size produce significant computational challenges, particularly during implementation. Consequently, many banks have to recode models during implementation, which poses significant model risk and deployment delays. Thus, a proper model governance process is critical to reduce model risk.

Is stress testing just about stressing financial statement elements and capital?

Haines: No. Most of the regulations also require banks to provide qualitative information on methodologies used to develop internal projections of capital across scenarios. In addition to providing stress test results, banks need to fully document how the results were derived. As many banks still have manual processes to reconcile and aggregate results from different systems, auditability and documentation can be daunting tasks — especially when integrating risk and financial data for financial statement projections. If we had to speculate, use tests may be next — where standard practices such as capital allocation and pricing would be reviewed under stress scenarios.

Why do you think there is so much emphasis on the qualitative aspects of the stress testing process?

Haines: Consider Basel II implementations where credit scoring, lending and RWA capital computations became audited processes. With firmwide stress testing, the increased level of scrutiny placed on the governance aspects of the process may prevent banks from passing the stress test even if the binding constraints like capital ratios and leverage ratios are met. Over the past few CCAR cycles, the qualitative expectations have increased exponentially. Banks are not only expected to comply but also constantly refine and improve their processes. Even though the quantitative measures are the ones that are binding, the qualitative aspects under each regime have become just as important to the regulators. This reinforces the need for a well-defined and governed process and workflow.

What are the major hurdles banks face in developing capital plans?

Haines: In short, the major challenges involve integrating risk, finance and economics from both a systems and organizational perspective. These functions have typically operated in independent silos, but to incorporate stress testing into capital planning, significant cross-functional collaboration is required. Today, the risk staff understands very little about the process of projecting the balance sheet (outside of pure portfolio stress testing) and the finance staff understands little of the quantitative mechanics used to project losses. Yet, both teams must work in concert to develop these plans.

Collaboration also is required to provide management with the details behind stress testing results, enabling them to successfully defend test outcomes to regulators. Understanding balance sheet and capital ratio sensitivities is ultimately the biggest hurdle banks face in capital plan development. Banks need formal structures to integrate forecasting from financial planning and capital management into their risk management processes in a timely and accurate fashion.

Are there any other challenges banks are experiencing?

Haines: Banks need models to project the regulatory-prescribed macroeconomic scenarios into actual risk factors that banks have in their books of business, and their currently in-use models may not be adequate for firmwide stress testing. It is difficult to separate earnings projections to ALM systems and loss projections to credit systems, for example, because of the associated interdependencies. Consequently, many banks not only have to revisit the model management of their existing CCAR and DFAST models but also have to build new models for firmwide stress testing purposes—and that process needs to be managed and reconciled with the existing bank models.

Besides the collaborative nature of risk and finance, are there other specific challenges for bank personnel?

Haines: Because model insight and expertise are limited, huge burdens are placed on key people. Banks are aggressively recruiting experienced staff, causing some to go as far as having agreements with each other not to poach resources. Plus, burnout from the CCAR cycle occurs frequently, so much so that the Federal Reserve has provided a relief clause to banks, shifting CCAR reporting to 2015 to give banks some relief for their staffs over the upcoming holiday period.

This article was originally published by Argyle Journal and is republished here with permission.

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