Effective Stress Testing In Global Finance

By M. Isi Eromosele

The depth and duration of the financial crisis has led many banks and supervisory authorities to question whether stress testing practices were sufficient prior to the crisis and whether they were adequate to cope with rapidly changing market conditions.

In particular, not only was the crisis far more severe in many respects than was anticipated by banks' stress testing results, but it was possibly compounded by weaknesses in stress testing practices in reaction to the unfolding events.

As the global financial crisis continues, numerous lessons have emerged from this episode that must be seriously considered by the global financial industry.

Stress testing is an important risk management tool that is used by banks as part of their internal risk management practices and, through the Basel II capital adequacy framework, is promoted by regulatory supervisors.

Stress testing alerts bank management to adverse unexpected outcomes related to a variety of risks and provides an indication of how much capital might be needed to absorb losses should large shocks occur.

While stress tests provide an indication of the appropriate level of capital necessary to endure deteriorating economic conditions, a bank alternatively may employ other actions in order to help mitigate increasing levels of risk. Stress testing is a tool that supplements other risk management approaches and measures.

Stress testing plays a crucial role in:

• Providing forward-looking assessments of risk
• Overcoming limitations of models and historical data
• Supporting internal and external communication
• Feeding into capital and liquidity planning procedures
• Informing the setting of a banks’ risk tolerance
• Facilitating the development of risk mitigation or contingency plans across a range of stressed conditions

Stress testing is especially important after long periods of benign economic and financial conditions, when fading memory of negative conditions can lead to complacency and the underestimating of risk.

It is also a key risk management tool during periods of expansion, when innovation leads to new products that grow rapidly and for which limited or no loss data is available.

Pillar 1 (minimum capital requirements) of the Basel II framework requires banks using the Internal Models Approach to determine market risk capital to have in place in a rigorous program of stress testing.

Similarly, banks using the advanced and foundation internal ratings-based (IRB) approaches for credit risk are required to conduct credit risk stress tests to assess the robustness of their internal capital assessments and the capital cushions above the regulatory minimum.

Basel II also requires that, at a minimum, banks subject their credit portfolios in the banking books to stress tests. Oseme Finance research has indicated that banks’ stress tests did not produce adequate large loss numbers in relation to their capital buffers going into the ongoing financial crisis or their actual loss experience.

Furthermore, banks’ firm-wide stress tests should have included more severe scenarios than the ones used in order to produce results more in line with the actual stresses that were observed.

A stress test is commonly described as the evaluation of a bank’s financial position under a severe but plausible scenario to assist in decision making within the bank. The term ‘stress testing’ is also used to refer not only to the mechanics of applying specific individual tests, but also to the wider environment within which the tests are developed, evaluated and used within the decision-making process.

In order to effectively implement effective stress tests, global financial institutions need to have in place:

• A robust framework to project cash flows arising from assets, liabilities and off balance sheet items over an appropriate set of time horizons
• A contingency funding plan to deal with a liquidity crisis, which should set down how the firm will meet time critical payments, allocation of roles and responsibilities, escalation procedures and the impact of stressed market conditions on the firm’s ability to sell or securitize assets
• The ability to perform stress testing on an institution on a specific and market wide basis, and to assess the impact of these stresses on cash flows, liquidity position, profitability and solvency
• Reliable management information systems to provide the firm’s governing body, senior managers and other appropriate personnel with timely and forward-looking information on the liquidity position of the firm

Benchmarking And Frameworks

The financial crisis has highlighted weaknesses in stress testing practices employed prior to the start of the crisis in four broad areas: (i) use of stress testing and integration in risk governance (ii) stress testing methodologies (iii) scenario selection and (iv) reverse stress testing.

Use Of Stress Testing And Integration in Risk Governance

The financial crisis has revealed weaknesses in organizational aspects of stress testing programs. Oseme Finance uncovered that prior to the crisis, stress testing at some banks was performed mainly as an isolated exercise by the risk function with little interaction with business areas.

This meant that, among other things, business areas often believed that the analysis was not credible. Moreover, at some banks, the stress testing program was a mechanical exercise.

While there is room for routinely operated stress tests within a comprehensive stress testing program (e.g. for background monitoring), they do not provide a complete picture because mechanical approaches can neither fully take account of changing business conditions nor incorporate qualitative judgments from across the different areas of a bank.

Furthermore, in many banks, stress tests were carried out by separate units focusing on particular business lines or risk types. This led to organizational barriers when aiming to integrate quantitative and qualitative stress testing results across a bank.

Stress Testing Methodologies

Stress tests cover a range of methodologies. Complexity can vary, ranging from simple sensitivity tests to complex stress tests, which aim to assess the impact of a severe macroeconomic stress event on measures like earnings and economic capital.

Stress tests may be performed at varying degrees of aggregation, from the level of an individual instrument up to the institutional level. Stress tests are performed for different risk types including market, credit, operational and liquidity risk.

Notwithstanding this wide range of methodologies, Oseme Finance analysis revealed several methodological weaknesses.

At the most fundamental level, weaknesses in infrastructure limited the ability of banks to identify and aggregate exposures across the bank. This weakness limits the effectiveness of risk management tools, including stress testing.

Prior to the global financial crisis, most banks did not perform stress tests that took a comprehensive firm-wide perspective across risks and different books. Even if they did, the stress tests were insufficient in identifying and aggregating risks.

As a result, banks did not have a comprehensive view across credit, market and liquidity risks of their various businesses.

Scenario Selection

During pre-crisis stress tests, scenarios tended to reflect mild shocks, assume shorter durations and underestimate the correlations between different positions, risk types and markets due to system-wide interactions and feedback effects.

Prior to the global crisis, severe stress scenarios typically resulted in estimates of losses that were no more than a quarter’s worth of earnings of the institutions.

Across the industry, a range of techniques has been used to develop scenarios. Sensitivity tests, which are at the most basic level, generally shock individual parameters or inputs without relating those shocks to an underlying event or real-world outcomes.

More sophisticated approaches apply shocks to many parameters simultaneously. Approaches are typically either historically based or hypothetical.

Reverse Stress Testing

Stress tests should be aimed at the events capable of inflicting the most damage whether through size of loss or through loss of reputation. A stress testing program should determine what scenarios could challenge the viability of the bank (reverse stress tests) and thereby uncover hidden risks and interactions among risks.

Commensurate with the principle of proportionality, stress tests should be geared towards the most material business areas and towards events that might be particularly damaging for the firm. This could include not only events that inflict large losses but which subsequently cause damage to the bank's reputation.

A reverse stress test induces banks to consider scenarios beyond normal business settings and leads to events with contagion and systemic implications. For instance, a bank with a large exposure to complex structured credit products could have asked what kind of scenario would have led to widespread losses such as those observed in the recent financial crisis.

Given the above scenario, the bank would have then analyzed its hedging strategy and assessed whether this strategy would be robust in the stressed market environment characterized by a lack of market liquidity and increased counter-party credit risk.

Given the appropriate judgments, this type of stress test can reveal hidden vulnerabilities and inconsistencies in hedging strategies or other behavioral reactions.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

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