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Benefits of a standard framework for stress testing

Tom KimnerThe need and usefulness of stress tests has been identified by regulators globally, and through efforts to meet Basel II and Basel III requirements, most banks have recognized this as well. Further, banks anticipate an increase in regulatory stress testing to determine standards for regulatory capital and the health of the financial services industry.

Stress testing is a collective term that describes techniques that can be used to estimate a portfolio’s potential losses when subjected to exceptional or extreme events. To perform stress testing, shocks are applied to risk factors, such as interest rates or foreign exchange rates that, in turn, drive the value or cash flows of instruments in the portfolio. In this way, portfolio performance can be examined assuming extreme movements in the underlying risk factors. Ideally, this information is used by decision makers to either hedge or diversify a portfolio so that an extreme event will not wipe it out.

Successfully executing an enterprise stress testing program requires a technology framework that enables data, scenarios, analytics and reports to be integrated across the organization. Stress testing platforms should be flexible enough to enable lines of business, trading desk and corporate risk management groups to generate multifactor stress tests and store the information for later use.

Benefits of a standard framework for stress testing. Click on image for a larger view.

With an increased commitment to stress testing, there is a need to improve flexibility and efficiency around the process. A standard framework would provide many benefits.

Building this flexible stress testing capability within the financial institution would dramatically reduce the manual rework costs involved in creating timely stress tests. Banks and regulators would receive the benefits gained from best practices and from access to shared research, expertise and learning.

SAS has been at the forefront of stress testing

Regulators around the world continue to emphasize that firmwide stress testing will be a major element of risk management for financial services. In the US, the first round of government-mandated stress tests provided useful capital adequacy insights, but was limited to approximating the capital buffer needed by the 19 largest US banks under highly generalized scenarios. Likewise, the recent stress tests in Europe were conducted using a set of equally generalized scenarios and simplifying assumptions.

In the future, government-mandated requirements for stress testing will become more comprehensive. In the US, the Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law in July 2010, requires the Federal Reserve to ensure that large and midsized financial institutions perform annual or semiannual stress testing. The act reinforces the need for comprehensive and transparent risk analysis across the firm. Regulators will specify processes and methodologies for financial institutions to assess capital adequacy under baseline, adverse and severely adverse scenarios.

Similarly, regulators in the EU will be implementing new stress testing procedures that will be required of most financial institutions in that region. These stress tests will be more comprehensive in nature than in the past and will be required on an annual basis at a minimum.

SAS has seen customers realize up to a 50 percent reduction in stress testing costs while improving system performance dramatically.

Banks will need to respond to the stress tests quickly while clarifying relevant risk factors and guidelines. Both the US SCAP and EU stress tests provided an unprecedented view of bank assets, but required weeks of manual position aggregation on spreadsheets. Given the short time frame, neither of these stress testing initiatives addressed the creation of repeatable processes or persistent infrastructure. Moreover, consistency of test results was not guaranteed, as multiple versions of disparate data, valuation methods and stress testing models persisted within and across institutions.

The stress testing capability of SAS is designed to speed the process of stress testing, while also being flexible enough to address future regulatory requirements. The SAS stress testing platform can enable firms to streamline the firmwide stress testing process by facilitating the integration of data and analytics into one stress testing environment. In previous engagements, SAS has seen customers realize up to a 50 percent reduction in stress testing costs while improving system performance dramatically. By using SAS for stress testing, many groups within an organization – including IT, risk management and lines of business – can realize significant benefits.

Here is a white paper that covers this topic in more depth. Download it now, and then check back here if you have more questions. I’d also like to hear what you are thinking about stress testing issues and recent regulatory changes.

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