Last year’s credit crisis illuminated all too well the shortfalls of stress testing procedures in markets around the globe, including those at work in US financial institutions, as existing capabilities failed to accurately predict the potential impact of extreme scenarios at the enterprise level.
The siloed nature of stress testing at most financial institutions, where each individual line of business conducts its own tests, played a prominent role in this failure. This incongruous approach prevents the bank from achieving an accurate view of its overall business by applying inconsistent definitions across each line of business and conducting tests at different points in time so that each segment tests a different set of data. As a result, this siloed process consistently yields an inaccurate assessment of enterprise-level risk, particularly for extreme scenarios.
Regulators have realised these shortcomings and are responding with increased regulatory requirements for stress testing. We have seen this in Europe from the Basel Committee on Banking Supervision, and similar requirements are emerging in the US.
The call for more robust stress testing coupled with accelerated deadlines for conducting tests requires a new level of agility, but many financial organisations are finding that their legacy systems do not provide the agility required to quickly implement changes and adapt data models and scenarios to enable accurate, enterprise-wide stress testing processes.
To meet these needs, achieve more accurate results moving forward and prevent a recurrence of the events of the last year, financial institutions are rethinking their entire approach to stress testing. Many are embracing a centralised or holistic approach to gain the enterprise-level insight required to effectively manage risk and mitigate threats to liquidity across their complex organisations in today’s uncertain market.
Enabling the Business with a Holistic Approach
A centralised and holistic approach to stress testing – one that enables institutions to centrally define and manage scenarios and shocks for a consistent enterprise-wide approach – can significantly improve an institution’s ability to accurately assess the risk appetite of the organisation under extreme scenarios. Financial institutions that adopt this model also gain the flexibility to compute current and future capital requirements under baseline and stressed conditions. With this approach, financial institutions can also effectively identify and control the liquidity risk of their organisation, both from a bank-specific and market-wide perspective, in accordance with regulatory requirements. More accurate liquidity stress testing will be critical to helping banks avoid extreme adverse events in the future.
Furthermore, organisations have the agility to execute model-based and deterministic stress tests over time and across all key risk areas for more accurate analysis. They can also leverage insight gleaned from extended visibility to enable more strategic decision-making regarding current and future capital risk. In support of compliance initiatives, financial organisations that centralise stress testing ensure a transparent and auditable process that enables them to clearly demonstrate organisation-specific risks and mitigation plans to potential reviewers and regulators.
Critical Components for Achieving Enterprise-wide Insight
The mission for financial institutions is clear. Many, however, struggle with first steps toward achieving enterprise visibility and the ability to move forward quickly. To begin, an organisation must define the measures it needs to submit to stress testing. This list of measures should include elements from the assets and liabilities segment of the balance sheet, as well as income and liquidity areas, such as liquidity gaps, net interest income, forecasted credit losses and trading book losses.
The next step is to identify a standard stress testing approach for each of the identified risk measures. The complexity of these methodologies may vary depending on the nature of the variable being stressed. For example, institutions may use a rolling rate-based model for stress testing retail loan losses and an economic value-based model for stress testing wholesale loan losses
To ensure consistent testing, financial institutions must also establish a centralised repository of scenarios. Financial institutions should develop scenarios, defined as shock-to-risk factors, from multiple sources of input that may include judgment from business managers and economists, as well as quantitative assessments. Within these scenarios, they must ensure that the specification of shock allows for multiple techniques, such as absolute shift, standard deviation shift, term structure twists and inversion and time referencing.
In addition to a central repository of scenarios, financial institutions require a unified repository of models to enable accurate assessment of the interplay of multiple risk factors. In addition, organisations must be able to pull in models residing in multiple silos without altering their calibrations. By establishing a centralised repository for both scenario and modelling information, financial organisations can effectively collapse previous data silos and gain an enterprise-wide view of the impact of a particular scenario across all books of business.
To consistently define scenarios, financial organisations must identify specific risk factors – such as gross domestic product (GDP), unemployment rate, sovereign interest-rate term structure, oil and energy prices and stock indices – which serve as indicators of economic conditions. They should pinpoint which conditions influence their particular risk profile and use techniques – such as auto-correlation and factor analysis, in conjunction with expert judgment and other statistical methods – to identify the risk factors relevant to each segment of their portfolio.
In order to support these centralised repositories and truly enable an enterprise-wide stress testing approach, financial institutions will first need to ensure they have the appropriate IT infrastructure in place. They will require modern, integrated solutions that can couple data management capabilities with the complex computations required to stress a wide variety of risk measures using multiple scenarios. These solutions will enable senior management to make strategic decisions on risk mitigation, capital management and business planning.
The Agility to Adapt
A holistic approach to stress testing delivers the speed, agility and accuracy that financial institutions require to adapt to constant market changes and deliver stress testing results quickly, which is essential as regulators increasingly request more rapid turnaround on results.
For C-suite level executives, a holistic approach enables them to accurately assess the bank’s risk appetite and identify risk hot spots. It also provides the information required to plan for business growth and allocate scarce capital to business units based on the risk appetite.
For example, a major Canadian bank has been able to keep pace with increasingly rigorous Canadian risk management requirements by centralising its stress testing operations. Two years ago, the bank implemented its enterprise-wide risk management solution to gain the ability to accurately and rapidly respond to regulatory requests. The robust solution enables the bank to maintain compliance as regulators request increasingly complex stress testing scenarios. Today, the bank can complete tests and deliver results to regulators rapidly, sometimes in just a few days. Other banks in Canada and the US are recognising the benefits of a holistic approach and beginning to follow suit.
After an unprecedented credit and liquidity crisis, the road to success for global financial institutions has changed dramatically. Organisations that are swift to adopt a holistic approach to stress testing will achieve the consistent and accurate insight required to reaffirm their credibility and thrive in today’s fast-changing market.
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