Stress Testing

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One of the major outcomes of the Credit Crunch has been that banks, regulators and the whole financial market have had to question the validity and even usefulness of some standard risk management systems. Why was it that so many
institutions were overextended in the credit
boom up until the summer of 2007 and why
weren’t risk controls flashing appropriate
warning signs? Given that very few early
warning signals were triggered, what can be
done to improve our risk management systems
in the future?

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Stress Testing

  1. 1. Stress TestingUniversal Banking Solution System Integration Consulting Business Process Outsourcing
  2. 2. Introduction • little consideration was given to system-wideOne of the major outcomes of the Credit Crunch outcomes of tests and particularly the adversehas been that banks, regulators and the whole effects that could arise from the behaviour offinancial market have had to question the validity other firms in markets or via the real economyand even usefulness of some standard risk in response to those stresses.management systems. Why was it that so many In addition standards were observed to beinstitutions were overextended in the credit below acceptable practice, with some institutionsboom up until the summer of 2007 and why having insufficient holdings of liquid assets.weren’t risk controls flashing appropriate In addition the age old problem, of bankswarning signs? Given that very few early cutting corners by funding their portfolios ofwarning signals were triggered, what can be illiquid asset with short-term liabilities. Anddone to improve our risk management systems equally important far too many institutions hadin the future? insufficient detailed information in their cash-flow projections and frequently lacked rigorous liquidityThis state of affairs has caused regulators, often contingency plans.pressed by politicians who have had to calmvoters concerns, to look for additional new Now it is all change – over the past yearapproaches for measuring and managing the regulators have devised a much morefinancial risk. Clearly there is no magic bullet comprehensive regime – will it work? For bankthat can warn for every eventuality but equally treasurers this new stress testing regime reallyrelying on ever more sophisticated manipulation means liquidity risk (though of course it canof data from the past doesn’t always seem to equally be deployed to assess credit exposures,work. One area that almost immediately attracted market risk and operational risk). What are thethe regulators was increasing the use of stress challenges? How can the best approaches betesting – this in many ways is not a new idea employed, what new skills are needed, will therebut perhaps more sophisticated approaches be software requirements and what exactly docould be used to plug some of the gaps in the the regulators expect?existing risk systems? Certainly the Turner Liquidity Risk DriversReview (which examined the causes of the credit Starting with regulatory demands, the key changecrunch, the impact on the financial sector and has been to identify ten Liquidity Risk Drivers,possible remedies for the future) in London took and critically banks have to demonstrate howthis view and this has been embraced by the these are incorporated into two specific types ofmajor regulators around the globe. Whilst some scenario; these being the idiosyncratic scenariostress testing had been conducted in the past plans and the market wide scenario plans. Theit had been rather limited in its scope and idiosyncratic plans test for a liquidity event athad clearly not helped in identifying problems the individual institution, and the market widefor many major banks during the unfolding plan is to see how an overall market eventcredit crisis. would impact an institution’s liquidity. The idea isTo quote the FSA in London (whose thinking is in that from these scenarios banks can model theirline with the major regulators) liquidity buffers and then have to demonstrate that such buffers are in place and meet theDeficient stress testing was identified as one of the continuous requirements regarding their liquidity,failures that contributed to the current financial and credit worthiness (in broad terms thesecrisis in the following ways: buffers have to be cash, balances at central• Firms devoted insufficient resources to stress banks and government securities issued by testing before the crisis; major countries as listed by the regulators).• Firms and regulators failed to test against These plans also come with both quantitive and sufficiently extreme macroeconomic qualitive assessments. Naturally enough the outcomes; and former is well suited for developing appropriate Stress Testing
  3. 3. software but the latter takes banks into the • External funding sources will have to bepossibly unfamiliar territory of scenario planning. continuously available to all the bank’sHere judgements and methodologies are much internal risk and pricing applications.more fluid and a different management approachis needed. This will need new skills for manybankers – and it may well be that staff are All of this means that connectivity to marketsrecruited from other sectors (e.g. the Oil where the assets in question are traded or valuedIndustry, Chemicals and Pharmaceuticals) where is even more critical than currently. Pricing andsuch planning techniques are well understood valuation data has to be captured and updatedand established. on a continuous basis – and across what may be a plethora of existing legacy systems. Of courseThere are also spin off business effects from much of this work is already done, but now it willthis new liquidity framework. With a much closer be under very intense scrutiny with the threat offocus on liquidity and crucially its true cost, punishing restrictions and controls imposed bythere will now be strong incentives for firms regulators if they feel a bank has not done itsto correctly price liquidity across business homework properly.units. This will help strengthen the commercial Finally the real issue surrounding stress testingviability of many firms as previously profitable is not just about data, systems and accuratetransactions and positions may be rather less liquidity provision and pricing – it is about seniorattractive when liquidity costs are truly accounted management’s ability to create and control thefor – so weaker deals are more likely to be rejected. complex systems required. This is no mean undertaking – the challenges range from newAnother area that this regime will shed light on specialist systems and IT upgrades, through tois the often complex liquidity issues regarding even better data and also how to blend in thecross border relationships within firms, the “soft” tools such as scenario planning andregulators now expect stress tests to examine reverse stress testing routines.any effects of poor liquidity across borders andjurisdictions. This has been shown by the Future Challengescollapse of Lehman Brothers to be an area fullof potential problems, some of which could Clearly the advent of more sophisticated stressprove disastrous if proper liquidity buffers and testing is a positive step – here are some of thecontingencies are not in place. major challenges and issues that could well emerge in this area in the future:Action Time for BanksAll of the above generates a huge amount of • Stress testing is not the new panacea andwork for the banks; consider the following issues has to be used in careful conjunction withfirms will need data and systems for: other tools. The key message is that stress• Calculating the cost of funding across testing (and the so called reverse method) different markets, aggregating the data and are complements to existing tools. It integrating internal systems to correctly also presupposes a great deal of data apportion those costs. integration across multiple locations and• Accurate and timely data to create correct timeframes – these are significant business risk-adjusted valuations for balance sheet and IT challenges. items – and to be able to calculate liquidity buffers on a continuous basis. • However “reverse” stress testing may prove to be a disappointment to regulators – it is• Banks will have to be able to monitor hard to believe institutions will devote more accurately their cost of capital over multiple than the minimum regulatory requirement on time periods. planning their own funeral. Stress Testing
  4. 4. • It is easy to make bad mistakes in scenario Further Reading planning – care and the use of tried and tested methods from other industries will For those interested in understanding how the be needed. It may well be that financial wider topics of futures planning and scenarios institutions (and perhaps the regulators) are conducted in other industries take a look at: will need to draw on planning talent from The Art of the Long View – Planning for the Future entirely new sectors so that they get the most in an Uncertain World by Peter Schwartz from the process. The Living Company by Arie de Gues• Stress Testing is not just another compliance issue – if managed correctly it can help improve the business going forward. It is also not a one off exercise – building a dynamic and continuous scenario planning process is the secret to getting the most from the process. Stress Testing

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