We are currently grappling with the biggest Black Swan event of our lifetime i.e. COVID-19. The crisis continues to unfold simultaneously in all parts of the world and never before have we experienced such widespread lockdowns of flights, trains, hotels, offices, restaurants and shopping malls, affecting life as usual across the globe. Financial institutions continue to do their best to provide essential services, but undoubtedly they will have to bear the direct and indirect repercussions of this unprecedented economic tsunami. The Central Banks are also monitoring the situation closely and have announced various relief measures in the form of stimulus packages and relaxed regulations. In current precarious and rapidly evolving situation, it is important for the senior management to be on the top of the risks in their portfolios. One of the most potent tools that the banks have in their arsenal is Stress Testing which allows them to simulate multiple hypothetical scenarios and assess the impact. The objective of this publication is to provide a practitioner's view on the evolution of stress testing practices and related challenges, along with the roadmap to an Integrated Stress Testing (IST) framework so that the same can be applied in times of COVID-19 crisis.
Stress testing is the evaluation of a bank's financial position under extreme historical and plausible hypothetical scenarios. Stress testing today has become a key aspect of Risk Management and Regulatory Supervision at banks and other FIs. It has also served as an important tool to address the shortcomings of Pillar I Framework, especially the standardized approaches, and has increased the awareness regarding Risk Management among senior executives and the board. Besides identifying management actions, stress-testing outputs are used to enhance capital & liquidity contingency plans, risk mitigation and management techniques, decision-making processes in strategic and financial planning, pricing and risk appetite setting.
Over time, we have seen many changes in the frameworks across several jurisdictions, prominent amongst them being (i) the greater use of analytical models, (ii) incorporation of scenario analyses and reverse stress testing, in addition to the sensitivity analysis, (iii) integrated approach to stress testing rather than silo based approach, (iv) strong governance as well as (v) linkage of results with business, capital and recovery plans.
Several regulators have also adopted standardized frameworks for stress testing to enable peer benchmarking and comparison. In such cases, regulators themselves specify the scenarios and key assumptions. Stress Testing started as an annual exercise in the initial versions of the regulations, but with time it has now become either a semi-annual or quarterly activity in most jurisdictions.
Regulators also expect the senior management and the board to have an active involvement in the challenge and approval process of the stress-testing framework and results. There have been instances where regulators have requested for proofs of any trainings conducted for them or have gone to the extent of scrutinizing the minutes of the approval committee meetings. It is expected that banks' stress tests be not only used for regulatory compliance but also feed into the management decision making for the setting of risk appetite, business and capital plans.
Another key development in the recent past is the issuance of a plethora of new regulations such as Basel III, Counterparty Credit Risk, IRRBB (BCBS 368), IFRS9, ILAAP etc. These regulations have elements of risk analytics that overlap with the existing stress testing frameworks, exhibiting a big scope of alignment.
In addition, all the above-mentioned regulations require a forward-looking assessment involving forecasts of bank specific and market wide factors like balance sheet size, GDP, oil price, inflation, real estate prices and others. Ideally, a bank should have a consistent view of these factors across all such regulations at least in the base scenario.
Though on one hand, the stress testing and analytical practices have evolved in terms of coverage and sophistication, on the other they largely remain compartmentalized within key risk types. For instance, separate risk models for credit, market, interest rate and liquidity continue to run on their own sets of data, assumptions and methodologies in many banks. The individual impact of each risk type is then added to get the final losses or risk weighted assets (RWA).
Instead of looking at the key risks in silo, it is time for banks to start adopting an Integrated Stress Testing (IST) Framework where the scenarios, data and risk models across the organization are linked on the basis of their interdependencies. However, this involves several challenges:
In the context of above-mentioned challenges, it is difficult to have an ideal IST framework where all the data and models are either seamlessly connected or replicated. Hence, we present a practical framework to implement Integrated Stress Testing (IST).
One of the foremost functions is to form a taskforce for IST, including representatives from various risk divisions, risk data/solutions and financial reporting led by an experienced Risk Analytics personnel. An exercise of such magnitude requires work in close coordination over a duration of 6-8 weeks as the numbers go through multiple rounds of stakeholders discussions, feedbacks and optimizations, before the final sign-off at the Board level.
The policy and regulations broadly define the horizon, frequency and key principles of the exercise which are supposed to be consistent across banks in a particular country. However, At the Implementation level, large differences can still be observed in the sophistication and granularity at which the exercise has been carried out.
The diagram on the following page represents the best practice Integrated Stress Testing (IST) Framework.
Lack of adequate quality data is often cited as one of the challenges to the credibility of IST sophistication. The following aspects are important:
A high level illustrative
The typical practice is to define Idiosyncratic scenarios for key risks along with several Systematic scenarios. They may be either based on historical experience or can be hypothetically conceptualized and are typically defined in the form of crisp and short qualitative statements. This task is handled by an economist in large banks whereas smaller banks usually rely on reputed third party research reports. Few regulators also provide a list of minimum scenarios that need to be covered.
Sample scenarios for the current COVID-19 situation can be conceptualized as follows:
The typical market practice is to define a base case and three stressed scenarios. However, this may differ across regulators. The following suggestions maybe useful -
The core aspect of the IST exercise is to identify all the material risk and business growth factors.
For example, the impact of credit stress because of increase in delinquencies/non-performing loans and reduction of available Tier 1 and Tier 2 capital is taken into consideration to assess the impact on LCR and NSFR ratios. The liquidity stress horizon is assumed to correlate with credit stress in such a way that the full impact of credit stress during a year is considered in the liquidity stress testing. Further, the impact of liquidity stress through increased cost of funding to rollover deposits and management actions required to cover for stressed run-offs can be included in reassessing capital adequacy ratios.
The impact of Stress Testing is computed for key regulatory and internal ratios like provisioning, liquidity and capital under base case and stressed scenarios. It also provides critical inputs for banks' Contingency Funding Plan and Recovery Plan. Furthermore, there should be a clearly defined Management Action Plan based on the Risk Appetite triggers. It may lead to iterative adjustments in strategic plan like no dividend payment or management bonus, reduction of credit growth, asset sale or raising of additional capital etc. The end objective is to make sure that the forecasted final key metrics remain within control.
The Bank's management shall formulate realistic actions (board-approved strategies) as required, vis-a`-vis the following:
An ideal IST solution should be able to combine all the underlying components including data, risk factors, models and scenarios to generate output in desired formats. The high-level functionalities of the key modules are listed below:
The following aspects are important for design and implementation of an efficient IST solution:
The following IST deployment options emerge in increasing order of sophistication of the framework:
We at Aptivaa continually strive to enhance our Stress Testing frameworks in line with global regulations and best practices. We have developed a range of advisory, analytical and IT solutions for implementing stress testing frameworks at several financial institutions. We look forward to hearing back from you on this subject, the challenges faced by you or any suggestions that you may have. Please feel free to contact us at
Regional Director - Client Relationship (MEA Region)
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