Stress testing banks

STRESS TESTING ? WHERE THE BANKS GOT IT WRONG & THE WAY FORWARD

BY

DR. EMMANUEL ABOLO

CHIEF ECONOMIST & HEAD, GROUP MARKET RISK ACCESS BANK PLC

LAGOS

July 29, 2010 RIMAN RISK CONFERENCE 2010, LAGOS

What is Stress Testing? Type of Stress tests Stress Testing: What is the Purpose? Business Benefits of Stress Testing Drivers of Stress Testing Key Elements of a Stress Testing Process Practical Issues Stress Testing: Where Banks Got it Wrong Stress Testing for Banks: The Way Forward Conclusion & Recommendations

July 29, 2010 RIMAN RISK CONFERENCE 2010, LAGOS 2

July 29, 2010 3RIMAN RISK CONFERENCE 2010, LAGOS

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• Stress testing refers to:

“the analytical process involved in subjecting a bank’s

portfolio to a series of battery of tests, designed to study the performance of the bank’s portfolio under extreme adverse conditions to generate the potential risk measures under plausible events in abnormal markets”.

“a set of statistical techniques to help assess the vulnerability of financial institutions and financial systems to exceptional but plausible events”.

“a set of integrated, multivariate tests that show degrees of severity for scenarios”.

RIMAN RISK CONFERENCE 2010, LAGOS

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Key Points



Micro Stress Tests

Designed to assess resilience of individual financial institution Mainly run by individual financial institutions for the purpose of

institutional risk management Often ignores behavior of competitors

Macro Stress Tests

Designed to assess resilience of financial system as a whole rather than individual institutions only

Run by central banks, IMF

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Type of Stress tests


By aggregation

• Individual exposures (Credit, Market, Liquidity risks).

• Individual institutions. • System - wide;

- on bank-by-bank data (“bottom up”)

- on aggregate data (identify common vulnerabilities across institutions).

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Type of Stress tests (Cont’d)

By method

• Sensitivity analysis: univariant tests i.e. moving key variables one at a time.

• Scenario analysis: multivariant testing.

• Contagion analysis• VaR: everyone’s favorite risk metric,

i.e. movement in the tail of the distribution representing the quantity of extreme loss. Note: risk is not linear in extreme events!

• Stochastic, e.g. monte carlo simulation- take up a number of randomized scenarios, ranging from modest to extreme instances.


Hierarchy & Overview

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Breadth

Depth


Sensitivity Analysis: Shock risk factor by large number of “standard

deviations”, i.e. assess the impact of large movements in financial variables

on portfolio values without specifying the reasons for such movements. Also

known as single-factor tests.

Identifies how portfolios respond to shifts in relevant economic

variables or risk parameters

consistent with daily risk management

takes into account probability of event


Scenario based: constructed either within

the context of a specific portfolio or in

light of historical events common across

portfolios

include “the unexpected”

consider highly correlated crashes

Forward-looking

Full-Blown Stress Test: The perfect storm

subject scenarios to multitude and

coincidence of extreme events and

pressures


Complements other Risk Management Techniques

Main objective is to make risks more transparent by estimating the potential losses on a portfolio in abnormal markets;

Often used to complement the internal models and management systems used by financial institutions for capital allocation decisions;

Can flex assumptions about business environment, e.g. market liquidity, ability to raise capital, competitive position, etc.

What if there is a crisis?

Primary purpose of stress testing is to form a rough idea of possible impact of extreme (but still plausible) shocks on the financial system or on a financial institution

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Stress-testing – What is the purpose?


Assists Senior Management

Assessing their views of risk Identifying risk concentrations Focusing on severe but plausible events Taking or planning mitigation actions

Broad Perspective Portfolio or business-wide perspective Multiple horizons – sometimes instantaneous, sometimes years

ahead Transparency Intuitive, easy to understand Management action visible

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Stress-testing – What is the purpose? (Cont’d)


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Supervisory & Banks’ Expectations


Stress-testing – What is the purpose? (Cont’d)

What does the regulator hope to achieve?

What does a bank hope to achieve?

Able to understand mechanism through which stress develops

Able to implement measures when the effects of stress events evolve into a vicious circle involving the real economy, financial markets and the banking sector.

Robust financial system needed to ensure monetary policy can achieve its objectives (e.g. price stability). The health of the financial system is inextricably intertwined with the performance of the economy and its resilience to shocks

etc….

Identify where the risk concentrations are?

Understand impact on bank if biggest customers default?

Impact on bank if historical worst-case scenario recur?

Impact on bank if it is hit by a similar severe credit loss event that affected competitors in the past

etc…

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Business Benefits of effective stress testing


Stress testing facilitates more informed decision making, allowing management to avert an undesired risk profile

Greater understanding of: - Impact of events on business plan - Risk concentration across multiple

business lines or units - Systemic vulnerabilities across the firm

Contingency planning allows firms to articulate what they would do in the event of a stress (i.e. the materialization of a risk they are willing to take)

Stress testing allows improved contingency planning and therefore more effective crisis response (e.g. quicker and more decisive action)

Improved consideration of correlations between different risk factors within a scenario

Reduced reliance on historical data that may be less relevant in stressed environment

Validation of internal capital models used to assess economic or regulatory capital

Clear communication and transparency for external stakeholders by considering capital adequacy or earnings volatility in terms of specific events

‘Translation’ of technical risk model output into tangible stakeholder story

Improved board and employee communication

1. Informed decision making

3. Contingency Planning 2. Model validation

4. Stakeholder Communication

Business benefits

Source : PWC

External Drivers

To comply with regulations: Basel II (mentioned 27 times in the document).

banks that use internal models to measure risks must conduct stress test (credit, liquidity, market)

- requisite for model approval

Internal Drivers

Banks: enhance market transparency & reputation;complete statistical models with information about losses; comply with local regulations.

Supervisors measure systemic risk & contagion effects understand tests undertaken by banks and ensure adequate risk management.

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Drivers of Stress Testing


Key Elements of a Stress Testing Process


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Key Elements of a Stress Testing Process

Majority of banks’ failures: Credit Risk Recession cycle: typically 2 years or more Default likelihood of counterparties or obligors: usually not within

the 1st year of getting the loan

Identify major exposures

Define Coverage

Background Understanding: identify macroeconomic & market risk


“Infrastructure” readiness: Sufficiency & types of data to cover good & bad times MIS & Data-warehouse capability Expertise (in-house or external)

Calibrate Shocks/Scenario selection & appropriateness (The 3 “Rs”): Relevance: Euro-centric events (Euro crisis) may not apply in Nigeria.

Realistic: Hypothetical Scenarios should be plausible in local context, e.g., LTCM-type loss events may not be applicable to our markets.

Reliable & Readily Available Database: The Scenario chosen should be one where the institution is able to collate and analyze the data pertaining to it.

Select & Implement Methodology Interpret and Implement Results

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Key Elements of a Stress Testing Process (Cont’d)


Yes No

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Ensure Reliable Data

Survey Portfolio & Environment

Identify Risk Factors

Construct Stress Tests

Run Stress-tests using counterparty &

portfolio risk models

Estimate bottomline of

counterparties under stressful conditions

Calculate Stress Loss

Report Results

Take Corrective Action, if required

Reassess Stress tests for appropriateness

Does the Bank possess quantitative risk

measurement systems?

KEY ELEMENTS inSTRESS TESTINGFramework


Key Elements of a Stress Testing: Schematic



Indentifying the relevant institutionsBanking sector only?Only systemically important institutions?

Indentifying the main sources of riskWhich types of risk?Combination of credit and market risk?


Financial institutions other than banksInsurance companies?

Aggregation between banks and non-banksScope of consolidation?

Interlinkages across banksInterbank exposures, contagionOther links (common exposures and funding

sources)


Financial crises rarely have the same characteristics:

“Econometricians among my friends tell me that rare events such as panics cannot be dealt with by the

normal techniques of regression, but have to be introduced exogenously as “dummy variables” (Kindleberger, 1996)



Defining relevant scenarios: alternative approachesHistorical or hypothetical?

How to construct scenarios? (common or individual)

Sensitivity analysis or full stress test?

Methodological issuesBottom-up or top-down approach?

Which time horizon?

Reduced form (satellite) models or structural models?

Piece-wise or integrated approach?


Should the findings be published?

Partially? In aggregated form?

How often should stress tests be run?

Annually, semi-annually, quarterly?

Who should run them?

Central bank?

Major banks in the country?


Confidence intervals around the point estimate of the dependent variable

How to construct confidence intervals at the tail of a distribution?

How to deal with non-linearities?Problem at times of stress



Most stress tests were simple sensitivity analysis; not stressful enough.

Adoption of too narrow a definition of plausibility. Extreme events are

unprecedented and involve a concatenation of events that seems implausible

before it happens. Did not “think outside the box”.

Stress tests were not conducted regularly (i.e. ad-hoc) which made it

impossible to understand changes in the risk profile or vulnerabilities of the

institution. Hence, new sources of surprises passed by.

The results of stress tests were rarely discussed and did not form part of the

risk management architecture.


Stress tests were conducted in silos and not integrated in a forward-looking

manner . Definitions of scenarios and methodologies used to stress test vary

across sections of the portfolio and entire organization.

Inter-bank contagion tests not conducted: impacts of contagion in the inter-

bank market, i.e. sensitivity of a bank to inter-bank contagion risk.

Stress tests were carried out as a stand alone exercise for the purpose of

show-off; results rarely used in risk management and capital planning

decisions.

No dedicated team for Stress Testing: an all-comer affair.

No framework or internal policies for conducting stress tests.

No reverse stress tests



As critical as stress testing may be, it’s not easy to get it right, e.g Bear Stearns and Northern Rock; Northern Rock’s risk executives came under heavy fire for not considering an unprecedented shut-down of funding markets as part of their stress testing program – and for not taking account of the degree to which their bank’s funding strategy was an ‘outlier’ among its peers.


THINK BIG – THE PLAUSIBLE EXTREME, NOT THE EXTREMELY PLAUSIBLE

Stress Testing should focus on extreme risks that lie well beyond the probability thresholds.

STRETCH YOUR IMAGINATION, NOT JUST YOUR RISK PARAMETERS

Historical scenarios are inevitably backward looking and cannot capture

changing risk profiles and risk interactions Spend more time thinking through hypothetical “what if” scenarios to

understand the underlying risk mechanics

USE DIFFERENT PERSPECTIVES TO BUILD COMPREHENSIVENESS Assess comprehensiveness of your stress testing against a range of

more dynamic and tailored perspectives: macroeconomic, systemic, etc


SILOS, CENTRALIZATION – OR INTEGRATION?

Individual business lines can’t see the whole picture; Stress tests run by bank’s separate risk management units may not

capture cross-risk interactions and knock-on-effects Whichever integrative mechanism a bank selects, the mechanism

should act as a clearing house for:

applying the best stress-testing methodologies at the local level mending gaps from a cross-risk and enterprise-wide

perspective building business line insights on risk accumulations and trends

(in the firm and the market) into stress testing activities


QUANTIFY WORST-CASE RISK INTERACTIONS Perhaps the most important function of stress tests is to make

clear the potential extent of the damage when risk factors interact together to create a radically severe outcome.

DON’T IGNORE BEHAVIORAL AND SYSTEMIC EFFECTS• Change in customer behaviour;• Change in stakeholder behaviour;• Change in counterparty behaviour;• Change in market behaviour;

- under stress plus required change• Other actors: regulators, rating agencies, investors, other banks,

shareholders, etc.


November 12, 2009 38RIMAN RISK CONFERENCE 2010, LAGOS

• Stress testing forms part of both Pillar 1 and Pillar 2 requirements of the Basel II Accord.

• Regulators require banks to report capital numbers under both baseline and stress conditions. Regulators are highlighting the need to have stress testing as a critical component of a bank’s risk management systems.

• In May 2009, the Basel Committee on Banking Supervision issued the final paper on “Principles for Sound Stress Testing Practices and Supervision”. This paper focuses on principles of conducting stress testing and the use of stress test results in strategic decision making.

• Key issues as stated in the document are as follows:


• Stress testing needs to form an integral part of the governance and risk management process. Board and senior management are to be the

ultimate owners of the stress testing program in the organization. Onus is on the senior management to use stress test results in operational and

strategic decision making.

• Stress testing needs to complement other risk management tools and models in identifying and managing risk across the institution. It should be rigorous and be able to identify scenarios that could have an adverse impact.

• Use of multiple techniques and processes for stress testing. These techniques range from use of deterministic parameter based stress tests to much more complex and evolved scenario models that use advanced statistical methods in estimating the impact of stress tests. Stress testing processes also need to factor the inter-related impact of a shock across risk categories.

• Institutions need to have a robust stress testing framework which is flexible and scalable to address current and future requirements.

November 12, 2009 40RIMAN RISK CONFERENCE 2010, LAGOS

Stress testing program should deliver a comprehensive assessment of enterprise-wide risk. This involves stress testing multiple measures across assets, liabilities, income and capital of the organization. This also includes use of multiple scenarios, of varying levels of severity, in assessing the vulnerability of the institution.

And finally, BIS requires banks to adopt reverse stress testing to identify scenarios that will cause maximum impact.



There is some danger that firms will try to learn the lessons of the latest banking crisis by increasing the number of historically-based stress tests they run in particular silo risk functions.

This would be to fail to learn the bigger lesson: banks must invest in the messy, at times unsatisfactory, enterprise-level business of understanding extreme, forward-looking risk interactions, dependencies and knock-on effects.

This is both an imaginative and a quantitative challenge – and it must be

organized in ways that overcome the silo mentality of bank businesses and bank risk management.


Stress testing must be relevant to the bank, its balance sheet and the

business environment.

Stress testing must be severe enough to reveal “tail” risk exposure (i.e.

improbable risk) without being completely improbable

Stress testing must be detailed enough to reveal vulnerabilities

Stress testing is not an end unto itself. Results have to be used in the risk

management process. Results should be carefully considered when

setting risk limits.

Stress testing should be made a regulatory requirement in Nigeria.

Banks need to also commence reverse stress testing: it would help explore

fully the vulnerabilities and “fault lines” in models, including “tail risks”.


Need for technology solutions that have robust data management and

modeling capability coupled with the flexibility to rapidly develop and

deliver stress tests results.

Banks need to have and use a central and common repository of scenarios

and models.

Banks also need to have in place methodologies to stress each of the risk

measures which may involve use of statistical techniques.


Data is key, but often unavailable Lack of manpower with requisite skill: need for

comprehensive training.

Several other challenges lie ahead, e.g. Incorporate feedback effects/knock-on effects Cross-border / cross-sector linkages




Education

Stress testing banks