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By M. Isi Eromosele
As the global financial crisis drags on and pressure mounts
on governments to take action, there are continuing strains in the economy,
unforgiving trial in the court of public opinion, volatility of markets and
complexity of financial products, institutions face new challenges in
recovering financial strength and restoring confidence.
To reaffirm their credibility, the leadership teams of
selected financial institutions are being tasked to build on the earlier albeit
short-sighted stress tests and address the broader purpose of sustainable
performance and stability.
To thrive in a fast changing world, stress testing and
scenario modeling will become a key governance practice and strategic tool at any
financial institution of substance.
Given the potential value that boards of directors and
management teams can derive from stress testing it has been identified as a
critical tool for risk management.
Stress Testing
Stress testing refers to the process of assessing the
vulnerability of financial institutions to extreme but plausible market
conditions. Stress testing covers multiple risk measures across categories and
complements traditional risk models.
It enables institutions to accurately assess risk and define
the "risk appetite" of the organization. Stress tests also provide actionable
information to senior management for decisions around capital allocation and contingency
planning.
Value-at-Risk (VaR) based methods are most commonly used to
assess risk across categories such as credit, market and operational risk.
These methods calculate risk as the worst case loss that can be incurred over a specified
time horizon with a given confidence level.
However, the recent credit crisis has highlighted the
limitations of these risk models and has firmly placed the spotlight on stress
testing as a critical and integral tool of risk management.
Current Approach And Inherent Challenges
Almost all banks have had some form of stress testing
running within the organization. These include stress testing using a range of
methodologies starting from deterministic parameter based to the more advanced
stochastic stress tests.
However, stress tests in most institutions, especially on
the banking book, are done in an ad-hoc manner. They are conducted by different silos
in the bank and definitions of scenarios and methodologies used to stress
test vary across sections of the portfolio.
Moreover, scenarios are not severe enough to reflect the
impact of financial crises in the event of change in these conditions.
As a result, institutions potentially fail to accurately
estimate the impact of a scenario at the enterprise level. Scenarios that could
have had a severe impact at an organization level get ignored in the silo
approach to stress testing.
Stress tests are carried out as a standalone exercise for
the purpose of regulatory reporting. Institutions rarely use these results in the risk
management and capital planning decisions.
Another challenge that institutions face is the “black-box”
and rigid nature of their risk management systems. Stress testing within these systems
is restricted to capital calculations and is used primarily for regulatory reporting.
These systems do not provide the ability to slice and dice
stress output by various dimensions so as to isolate the risk hot-spots,
thereby limiting its use as a strategic decision making tool.
Recommendations
Financial institutions need to adopt an enterprise-wide,
flexible and robust framework that is able to address the current and future
stress testing needs of the organizations.
Banks need to implement industry-standard technology
solutions that have robust data management and modeling capability coupled with
the flexibility to rapidly develop and deliver stress test results.
This includes the ability to have a common repository of
scenarios that can be used to deliver stress measures across banking and
trading book portfolios.
Business Goals and Requirements for Enterprise
Institutions will have to address several key issues in
adopting an enterprise-wide stress testing program.
One such issue is defining coverage in terms of the measures
that need to be stressed. The list of measures would include elements from the
assets and liabilities side of balance sheet, P&L and liquidity areas.
Stress testing this comprehensive list will provide an enterprise-wide view of
the impact of a scenario.
Banks need to have a central and common repository of
scenarios and models. Scenarios, defined as shock to risk factors, are to be
developed taking inputs from multiple sources including judgment from business
managers, economists and through the use of quantitative techniques.
Specification of shock needs to allow for multiple
techniques such as absolute shift, standard deviation shift and term structure twists and
inversion.
In addition to a central repository of scenarios, banks also
require a central repository of models. This model repository needs to pull in
models lying in multiple silos without altering their calibrations.
A central repository is a key step in providing an enterprise
wide assessment of stress, taking into consideration the interplay of risk
factors.
An important first step in definition of a scenario is the
identification of risk factors. Risk factors are indicators of economic
conditions and financial institutions need to identify the ones that influence
their risk profile.
An exhaustive list of such factors should be identified
based on expert judgment and verified using statistical methods. Institutions
need to use techniques such as auto-correlation and factor analysis to identify
the risk factors relevant to each segment of their portfolio.
Banks also need to have in place methodologies to stress
each of the risk measures. The complexity of these methodologies will depend on
the nature of the variable being stressed and would in general, involve use of
statistical techniques.
Holistic Approach
Enabling enterprise-wide stress testing would require
evolved technology solutions that can couple data management capabilities with
complex computations required to stress test a wide variety of risk measures
using multiple scenarios.
Stress testing approaches and regulatory requirements are
going to evolve rapidly. Banks will require technology solutions that are
extensible and are able to provide a central environment that can host models
existing in different silos of the organization and stress them in a holistic
manner.
These solutions would enable senior management to take
strategic decisions on capital management & business planning by providing
extensive capabilities on enterprise-wide stress testing.
M. Isi Eromosele is
the President | Chief Executive Officer | Executive Creative Director of Oseme
Group - Oseme Creative | Oseme Consulting | Oseme Finance
Copyright Control © 2012
Oseme Group
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