A lesson in effective stress testing
Integrated stress testing is the preferred tool from a supervisory perspective. And that’s on a global basis. It may not be new, but it is featuring increasingly higher on the regulatory agenda and so understanding the technological opportunities is all important. A key building block for effective and integrated stress testing is an integrated balance sheet strategy, writes Nancy Masschelein
As way of background, the Committee on the Global Financial System previously included stress testing in reviews of current practices, but it is now a regulatory requirement as part of the Basel process. The Basel Committee’s Principles Paper for Stress Testing Practices and Supervision is an influential paper to say the least as it is a base for all other requirements that have been published.
At the beginning of 2015, the Bank of England published its stress scenario alongside its Financial Stability Report in December. Governor Mark Carney called the Bank of England the “forward-looking regulator”. But in terms of the more onerous CCAR in the U.S, Europe is lagging behind. The EU has stress scenarios, where the European Banking Authority and European Central Bank work together. Currently, this process, which impacts approximately 130 banks, is fundamentally a bottom up exercise – where even the biggest firms have departments completely devoted to the exercise ensuring that they deliver the stress results on time.
The EBA published its 2016 EU-wide stress test draft methodology in November 2015 and announced that the next big exercise will be formally launched in the first quarter of 2016. The stress test will and will cover more than 70% of the EU banking sector and will assess EU banks’ ability to meet relevant supervisory capital ratios during an adverse economic shock.
While BCBS 239 is all about data aggregation and management, it too incorporates stress testing. Some of the key themes that this directive raises includes the following: “You need to have flexible effective stress testing capable of providing forward looking risk analytics” – this sounds plausible. “You need to forecast in areas for key market variables, needs to be informative to the Board and the Senior Management” – this shows that BCBS 239 is very much principle-based. It also raises the principle of adaptability. That principle states that you have to “… be able to generate a broad range of on demand ad hoc reporting risk management requests including requests during stress and crisis situations”. Many wonder who in the industry really feels comfortable with that.
As I said at the start, an important building block for effective and integrated stress testing is an integrated balance sheet strategy. A definition of this is “a balance sheet strategy that hides the liabilities in with the assets and vice versa no longer operating in isolation”. It is important that this is built consistently, following a contract-centric approach. On reflection the balance sheet of a bank represents a product catalogue where different financial contracts are grouped in different accounts. Key to an integrated balance sheet strategy, and hence integrated risk management, as well is that you generate the financial events and expected cash flow in a consistent way. This starts from the financial contract, taking account of input elements like market risk, credit risk, behavior, strategy and so on. Everything starts from the financial contract. A contract is a promise to exchange cash flows at a particular time. Whether the promise is kept depends upon contingency factors.
Input elements are numerous including market risk factors, interest rate, product rate, currencies, industries, commodities, volatilities and correlations, credit risk and counter-party credit risk. Collateral is key, as is customer behaviour. We just need to think back to 2008 and the queues going round the corner of Northern Rock in the UK to show how much customer behaviour can have such a big impact.
Of course, business strategy is important. All of these input elements impact contractual cash flows generating financial events and expected cash flows. Expected cash flows allow you to derive various risk metrics including liquidity risk metrics, market risk and credit risk scenarios and other volatilities that allow you reach real risk metrics. This is in support of an integrated risk management framework. Once you have this particular framework in place you can use it to run any stress or “what if” analysis, as you can use scenarios that are consistent taking account of all dependencies when you look at various metrics.
A key benefit of this is that it enables firms to draw their business according to their understanding of the underlying risk factors, with consistent stress testing. The minimum guarantee is that any assumptions are consistent and homogeneous for the different metrics that you run.
Modelling and analytics are not the only important factors. Integrated stress testing also requires banks to have clear processes in place. Banks all too often use silo risk systems, which may even be different in different regions and jurisdictions for legacy reasons. Challenges to run integrated stress analytics are numerous. A high reliance on risk silo systems means there is no auditable and controlled environment, where reconciliation work is carried out on spreadsheets. Reliance on spreadsheet technology clearly increases operational risk significantly and makes it nigh on impossible to run ‘what if’ scenarios quickly. In fact, it makes it impossible to adhere to the ad hoc analysis of BCBS 239.
There are, however, a number of resolutions including implementing an integrated risk and a budgeting system which actually sits on top of the risk silos. The advantage with this is that a bank has a single consistent calculation engine, so PDs can be reconciled with IFRS 9 and operational risk can be reduced because you are not dependent on aggregated spreadsheet results. More importantly, it allows ad hoc analysis in minutes. The burden of running stress tests is reduced, the board quickly has useful information and there is time to challenge and review results. It is key to have a controlled and an optimal environment. The bottom line is meeting stress testing requirements should not be a full time job.