The recent global financial crisis painfully revealed the need for better, more comprehensive stress testing in the financial industry. Stress testing focuses on analyzing risks associated with rare or extreme – but still relevant – events. Even if something that could go wrong never materializes, firms should still have a contingency plan for such events (i.e., a firm’s response to Murphy’s Law). A stress test is the foundation for this contingency plan, and serves to answer two types of questions:
How much could I lose under certain stress scenarios?
How could I lose more than X dollars?
When constructing stress tests, keep the following guidelines in mind:
- Put the scenarios in context. Practitioners need to determine how would (or how did) a hypothetical or historical stress test event unfold over time, rather than just considering the outcome.
- Conduct a relevant and realistic, forward-looking stress test that contains a description of the length, speed and magnitude of the event.
- Form a stress test committee. At a stress event’s first warning sign, the committee must communicate action steps that will protect the firm against potential extreme events.
- Determine what feedback is required throughout a period of extreme stress. Specify who acts on the results of a stress test, and what the appropriate follow-up with the risk takers is.
- Stress scenarios should have internal consistency in terms of the macro economic shocks of the stress test.
- Stress scenarios should have sufficient granularity. They should be conducted with sufficient detail to provide meaningful results at various subportfolio levels.
It’s also important to establish stress test limits. The purpose of stress test limits is to determine if the size of potential losses related to extreme events for the current portfolio is larger than the organization is willing to tolerate. Stress test limits should attempt to model a participant’s behavior and action taken to stay below a stress test limit in a stress environment. In other words, management response to an extreme event should be a critical component of the stress framework. Stress test limits also serve to meet regulatory requirements, such as Basel II.
Stress tests work well to highlight hidden weaknesses in a risk management system, such as hidden “hot spots” in a portfolio under extremely negative market conditions. Read about these and other best practices in my white paper titled Stress testing: A board-level issue.