Stress testing is one of the hot topics of the moment for risk management in banking. A ‘stress test’ is an analysis designed to check whether the bank is holding enough capital to be able to manage a rapid downturn. It is, basically, a way to test the resilience of the banking sector, and regulators have been keen on them since the 2008 financial crisis because they force banks to think about what they are doing, and also provide some data for regulators to consider.
Challenges and issues
Much of the current discussion on stress testing centres around its challenges, and it is fair to say that banks see a considerable number of challenges there. Perhaps one of the biggest is the model used, and how it fits with other tests such as IFRS 9 and Basel readiness. The fundamental issue is that the basis is different. A stress test can reasonably be combined with IFRS 9 readiness testing because the two use the same system (a point in time). However, Basel uses both point-in-time and single horizon, which makes it much harder to combine. And this, of course, means extra complexity and extra cost for the banks, which is never going to be popular.
Even that simple description of the basis of the test, however, masks a multitude of other issues. The stress testing baseline scenario modelling should be aligned with that for IFRS 9. It is, however, not clear how this should be done, or how banks can ensure consistency between the two. Finding the right criteria for model granularity is also a problem, because the staging requirements in IFRS 9 require loan level, and stress testing is more granular. Combining the two is therefore harder than it looks, and the impact of Basel 3 and IFRS 9 on the ICAAP and stress testing scenarios remains unclear.
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Central banks have helpfully added more layers to the complexity by prescribing scenarios and parameters. These, however, do not have to be used for stress testing purposes. There is also, from time to time, a mismatch between the regulatory scenario and what management would like to see used for internal purposes. An example of this is the EBA’s stress test, which requires banks to keep the balance sheet flat, whereas many banks would prefer to use dynamic balance sheets.
Developing practical use cases
The news is not all doom and gloom, however. For some time, financial services businesses have been trying to use stress testing for their own purposes — in other words, going beyond the absolute regulatory requirements, and making a virtue out of a necessary, to get some benefit out of the system for themselves. The phrase ‘business-driven stress-testing’ has been around for a couple of years now, and more use cases are emerging all the time.
More recent examples of new uses of stress testing include:
- Assessment of new product viability, for example, a new housing loan assessment tool, to improve risk management within the bank;
- Examining non-performing loans, again to improve risk management; and
- Using stress testing around acquisitions, to test portfolios ahead of purchase. It may also be possible to do a ‘reverse stress test’ before selling portfolios. Perhaps this is simply a revisiting of due diligence, but it is good to see banks using regulatory requirements to improve the way they do their business.
A practical response to regulatory requirements
One of the most interesting issues about both challenges and use cases is that they focus on connections: How the regulatory requirements and practical activities to address them fit together. Much of this is about disruption, and particularly its avoidance: How can banks combine requirements to ensure that ‘business as usual’ is not disrupted too much? And more, how can banks take what is required and make it more useful to them?
A part of it, though, is sounding more like a ‘shake-down’ (or possibly shake-up) of what has been put in place before. Solutions to regulatory problems are often, it would have to be admitted, tactical. Everyone does what needs to be done, and hopes that will be sufficient. But sometimes — as now — that starts to unravel after a while. Stress testing seems likely to push banks to revisit the existing arrangements, processes and systems for IFRS 9. It is not yet clear whether this will be a benefit or a problem, but it will certainly be an interesting challenge for many banks.
Where to next?
It will come as no surprise that this topic was discussed extensively at a recent Risk Executive Roundtable at AX2017 in Amsterdam. It is clear that the issue is exercising minds to a considerable degree, which is why we will continue to provide updates and answer frequently asked questions at the SAS Communities Risk & Finance Analytics section. Will you join us?