As everyone in the financial industry knows, CCAR (comprehensive capital analysis and review) was set up as a capital adequacy assessment for the major US banks. Through several years of practice and feedback, CCAR has evolved into a comprehensive stress testing exercise -- and in doing so, created a new enterprise risk management standard for the global banking industry.
In recent years, CCAR has extended to global banks that have significant operations in the US. And now we're seeing other regulators around the world, such as the Bank of England and the European Banking Authority (EBA) also adopting regular comprehensive stress testing in their jurisdictions. Although there are different levels of how comprehensive stress testing regimes are across the world, stress testing has definitely become a new enterprise risk management tool.
How much more comprehensive will stress testing become?
In the SAS white paper Firmwide Scenario Analysis and Stress Testing, my SAS colleague Jimmy Skoglund and I explore the evolution of stress testing. The journey has taken us from risk-specific stress testing to full balance sheet stress testing. This shift requires the cooperation and consolidation of all risk types, as well as financial and business planning.
Banks are now required to report stress testing on the plausible damaging scenarios that are specific to banking business operations. This is related to the so-called reverse stress testing. In addition to capital adequacy, banks are also asked to add liquidity to the stress tests.
And in addition to looking at the quantitative aspects of stress testing, regulators are also examining the bank's approach to end-to-end risk management governance -- including the risk data aggregation and reporting principles (a.k.a. BCBS 239), model risk management and the steps taken to deliver the end-to-end regulatory stress testing process itself.
Multiplying the impact
The methodologies employed in the major regulatory stress testing exercises have led to the convergence of risk and finance standards:
- The IASB (International Accounting Standards Board) finalized its IFRS 9 in 2014, replacing IAS 39 by 1 Jan 2018.
- IFRS 9 has abandoned the traditional incurred loss-based provisioning and embraced the forward-looking macroeconomic scenario based expected credit loss (ECL) approach.
- The US FASB (Financial Accounting Standards Board) has also proposed the same approach, which they refer to as Current Expected Credit Loss (CECL).
Adding to the list, banks must also contend with the new Basel Interest Rate Risk in the Banking Book (IRRBB), which has also introduced the forward-looking balance sheet and stress testing as key components for the pillar II interest rate risk. So it's clear that both provisioning and interest risk management will have a huge financial impact on the banking business.
In summary, what I see today is that enterprise stress testing is now established as an enterprise risk management framework which can go beyond just meeting a compliance requirement. Ultimately banks that embrace and apply the increasingly comprehensive stress testing exercises to their business planning and operation will gain efficiency improvements across the entire operation, which will also assist in managing the bank's reputation risk and increase its competitive advantage.
For more check out this SAS white paper: Firmwide Scenario Analysis and Stress Testing