A bank stress test is the analysis conducted under unfavorable economic scenarios designed to determine whether a bank has enough capital to withstand the impact of adverse developments. Especially in the years since the wake of the 2007-2008 financial crisis, it has been actively promoted by authorities and regulators as a prime tool for assessing the resilience of the major banking institutions in Europe.
The regulatory framework
The European Banking Authority (EBA) has published in June of 2017, its 2018 EU-wide stress test draft methodology and templates. The exercise will cover 70% of the EU banking sector and evaluates their ability to meet relevant supervisory capital ratios during an adverse economic shock. The evaluation will be based on a common methodology and a set of templates that capture starting point data and stress test results.
The methodology covers all relevant risk areas and will also incorporate IFRS 9 accounting standards for the first time. For banks starting to report under IFRS 9 in 2018, the 2018 EU-wide stress test takes into account the impact of the implementation of IFRS 9 (as of January 01, 2018). The results of the exercise will inform the 2018 Supervisory Review and Evaluation Process (SREP), challenging capital plans of banks and leading to relevant supervisory outcomes.
Changes over the horizon
Amidst a cataclysmic storm of regulatory requirements and strict deadlines, banks face significant challenges in executing the new methodology from EBA. The challenge is based on several issues arising from the new requirements and especially the complexity of the tests, related disclosure issues and the demand for additional inputs coming from the implementation of the IFRS9. As discussed by Susanne Hughes, director in Deloitte’s financial services risk advisory practice, the timetable for running the scenarios, guidance from supervisors and data requirements all contribute to this complexity. It continues to say that in 2018 in particular, banks will find it challenging to factor in a number of regulatory, accounting and structural changes that will take place over the horizon of the forecasts.
Rob Smith, a banking partner at KPMG UK, mentions that based on discussions with banks, significant challenges that are being identified include poor data quality and lack of automation of the processes. He also mentions that it is important that banks have the ability to perform dry runs to test the new or changed parts of the processes to avoid unnecessary issues during the stress testing cycle, issues that are expected to be exacerbated in the exercise of 2018 with the introduction of the IFRS 9 parameters. Similarly, Simon Brennan, director of regulatory strategy at Deloitte, even though convinced that the maturity and readiness of the Banks, as regards to running stress tests, has increased over the years, he is concerned that processes in general are still resource intensive and less flexible than is ideal.
Streamlining the process
Taking into consideration the above challenges, it is my opinion that banks should work on streamlining and embedding their stress testing process in their business as usual routines, so that the work performed is sustainable and can be repeated in an efficient manner. It is evident that especially smaller banks, due to the heavy regulatory workload, adopt a more ad-hoc approach to meet regulator’s demands. This results in a lack of a structured framework that establishes the governance needed, supported with formal roles and responsibilities, under which stress testing exercises can be executed successfully. This framework can help in using stress testing as a solid risk management and strategic planning tool. The results will continuously be feeding the strategic planning and decision-making process of the institutions so that any possible adversity is successfully factored in.
As discussed by Lee Thorpe, head of risk business solutions at SAS UK & Ireland, the key to executing a successful cycle is to have an agile, high performance environment with an associated model repository of interchangeable validated models. This framework will ensure that entire portfolios are utilising appropriate models, sensitive to the key risk drivers, models that have been through validation and review. A centralised, top-down approach will not only allow banks to remain flexible to changing risk policies and regulations, but also effectively track model issues, challenges and remediation across the business while allowing time for controlled changes to the process.
Integrated Risk platforms
It is of the outmost importance that banks work on building integrated risk platforms that provide a full governance framework, with strong data management and modelling capabilities that will allow for the flexibility and agility needed to keep up with the increasing demands of the regulators. These platforms will be providing the banks with the opportunity to:
- More effectively manage data-related issues, like data provisioning, data quality, data consolidation, data lineage and documentation and data aggregation. This includes meeting the need for the design and deployment of an integrated data repository for risk and finance data that will support the execution of forward projections with the same scenarios in a holistic fashion, and accurately map reporting taxonomies back to source data.
- Establish a robust model management environment to support model development, validation and implementation with the right governance throughout the model lifecycle.
- Consolidate all of the component pieces together in order to assimilate the entire set of required information, track important tasks, and allow for iterative analysis and reporting of the results, all while providing the necessary transparency and process documentation required by regulators.
Closing, I believe that the inclusion of the IFRS 9 point of view, in the stress testing exercise of 2018, is the point where banks will see current systems and processes fail. This is when institutions will identify the need for a more holistic and integrated view of risk through processes and technological frameworks that provide the agility, orchestration and transparency for the entire stress testing process.
To learn more, you can request the on demand webinar 2018 EBA Stress Test: How SAS can support