A Practical and Holistic Approach to Stress Testing in Financial Services: Strategies for Success

A Practical and Holistic Approach
to Stress Testing in Financial
Services: Strategies for Success

An Oracle White Paper
September 2009

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A Practical and Holistic Approach to Stress Testing in
Financial Services: Strategies for Success
EXECUTIVE SUMMARY
The unprecedented economic crises have
Having survived an unprecedented credit and liquidity crisis, the road to success for
highlighted the limitations of traditional
risk models and “silo’d” approaches to
global financial institutions will continue to change dramatically. With pressure
risk management. Stress testing has been
mounting on governments to take action, continuing strains in the economy,
identified as a critical tool of risk
unforgiving trial in the court of public opinion, volatility of markets, and
management.
complexity of financial products, institutions face new challenges in recovering
financial strength and restoring confidence. To reaffirm their credibility, the
leadership teams of selected financial institutions are being tasked to build on the
earlier albeit short-sighted stress tests, and address the broader purpose of
sustainable performance and stability.
To thrive in a fast changing world, stress testing and scenario modeling will become
a key governance practice and strategic tool at any financial institution of substance.
Given the potential value that boards of directors and management teams can
derive from stress testing it has been identified as a critical tool for risk
management.

INTRODUCTION
Stress testing refers to the process of assessing the vulnerability of financial
institutions to extreme but plausible market conditions. Stress testing covers
multiple risk measures across categories and complements traditional risk models.
It enables institutions to accurately assess risk and define the "risk appetite" of the
organization. Stress tests also provide actionable information to senior management
for decisions around capital allocation and contingency planning.
Value-at-Risk (VaR) based methods are most commonly used to assess risk across
categories such as credit, market and operational risk. These methods calculate risk
as the worst case loss that can be incurred over a specified time horizon with a
given confidence level. However, the recent credit crisis has highlighted the
limitations of these risk models and has firmly placed the spotlight on stress testing
as a critical and integral tool of risk management.
Stress testing is an integral part of both Pillar I and Pillar II requirements of the BIS
Capital Adequacy framework. In addition, the Basel Committee on Banking
Supervision (BCBS) has issued, in May 2009, a detailed document titled “Principles
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for Sound Stress Testing Practices and Supervision”. Financial institutions covered
by the Basel II accord on capital adequacy are required to follow these guidelines
on stress testing.
The guidelines emphasize the need to move away from the traditional, silo’d
approach to stress testing and move to an integrated and enterprise-wide stress
testing program. They also require banks to use stress test results as key inputs in
their strategic decision making processes.

NEED FOR STRESS TESTING
Recent credit crises have highlighted the limitations of traditional risk models.
Institutions typically use statistical methods and models for estimating risk and VaR
is among the most commonly accepted measure of risk. It is defined as the worst
expected loss over a given time horizon at a given confidence level. VaR methods
are used to estimate risk across categories including credit, interest-rate, equity,
commodity, etc.
However risk models suffer from certain limitations:
• VaR, as a risk measure, underestimates the occurrence and severity of tail
events. It measures risk as a percentile of the potential loss distribution
and ignores events beyond the percentile.

However VaR
VaR as percentile of the loss
calculations tend to
distribution the standard
ignore tail events
measure of risk across risk
categories

Figure 1: Tail Events Ignored by Traditional Risk Models
• VaR calculations are based on estimates of risk parameters such as default
probability, recovery rate for credit risk and mean reversion, volatility for
market risk. These risk parameters are estimated from historical data using
statistical techniques such as GLM, GARCH Etc. Historical data used to
calibrate risk parameter models often does not cover periods of extreme
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market conditions. As a result the predictive ability of these models
breaks-down under extreme market conditions.
• Risk models assume normal market conditions and are often not designed
to predict losses under extreme conditions
As a result, these traditional risk models were not able to predict the severity of
losses during the recent financial crises.
Stress testing complements existing risk models to provide a comprehensive
assessment of risk. It models tail events, therefore addressing limitations of
traditional risk models and enables institutions to assess potential losses across risk
categories due to extreme market conditions.

REGULATORY REQUIREMENTS AND IMPLICATIONS
Stress testing forms part of both Pillar 1 and Pillar 2 requirements of the Basel
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. These principles are applicable to all banks and are to be applied on a
proportionate basis. 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.
• In addition to other requirements, stress testing has been made the central tool for
identifying and controlling liquidity risk of the organization. Liquidity risk scenarios
need to cover both bank-specific and market-wide.
• 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.
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• 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.
These principles coupled with jurisdiction-specific regulatory requirements have
wide ranging implications for banks across the globe. At a minimum, bank’s will
need to put in place a central enterprise-wide stress testing framework that is able
to address key requirements including complex stress testing calculations, advanced
data management and ability to stress multiple risk measures across categories. In
addition, critical decisions such as capital allocation, risk based pricing, contingency
planning, etc. will have to factor in the results of the stress testing process. Banks
will also have to develop new models (or enhance existing ones) to assess the inter-
related impact of scenarios across multiple measures.

CURRENT APPROACH AND THE INHERENT CHALLENGES
Almost all banks have had some form of stress testing running within the
organization. These include stress testing using a range of methodologies starting
from deterministic parameter based to the more advanced stochastic stress tests.
However, stress tests in most institutions, especially on the banking book, are done
in an ad-hoc manner. They are conducted by different “silo’s” in the bank and
definitions of scenarios and methodologies used to stress test vary across sections
of the portfolio.
Moreover, scenarios are not severe enough to reflect the impact of financial crises
in the event of change in these conditions.
As a result, institutions potentially fail to accurately estimate the impact of a
scenario at the enterprise level. Scenarios that could have had a severe impact at an
organization level get ignored in the “silo’d” approach to stress testing.
Stress tests are carried out as a standalone exercise for the purpose of regulatory
reporting. Institutions rarely use these results in the risk management and capital
planning decisions.
Another challenge that institutions face is the “black-box” and rigid nature of their
risk management systems. Stress testing within these systems is restricted to capital
calculations and is used primarily for regulatory reporting. These systems do not
provide the ability to slice and dice stress output by various dimensions so as to
isolate the risk “hot-spots” thereby limiting its use as a strategic decision making
tool.

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RECOMMENDATIONS
Financial institutions need to adopt a
enterprise-wide, flexible and robust
Bank’s increasingly feel the need to have industry-standard technology solutions
framework that is able to address the
that have robust data management and modeling capability coupled with the
current and future stress testing needs of
flexibility to rapidly develop and deliver stress test results. This includes the ability
the organization.
to have a common repository of scenarios that can be used to deliver stress
measures across banking and trading book portfolios.



Figure 2: Business Goals and Requirements of Enterprise Wide Stress Testing
However, institutions will have to address several key issues in adopting an
enterprise-wide stress testing program.
One such issue is defining coverage in terms of the measures that need to be
stressed. The list of measures would include elements from the assets and liabilities
side of balance sheet, P&L and liquidity areas. Stress testing this comprehensive list
will provide an enterprise-wide view of the impact of a scenario
Banks need to have a central and common repository of scenarios and models.
Scenarios, defined as shock to risk factors, are to be developed taking inputs from
multiple sources including judgment from business managers, economists and
through use of quantitative techniques.
Specification of shock needs to allow for multiple techniques such as absolute shift,
standard deviation shift, etc. and term structure twists and inversion.
In addition to a central repository of scenarios, bank’s also require a central
repository of models. This model repository needs to pull in models lying in
multiple “silos” without altering their calibrations. A central repository is a key step
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in providing an enterprise wide assessment of stress - taking into consideration the
interplay of risk factors.
An important first step in definition of a scenario is the identification of risk
factors. Risk factors are indicators of economic conditions and institutions need to
identify the ones that influence their risk profile. An exhaustive list of such factors
is identified based on expert judgment and verified using statistical methods.
Institutions typically use techniques such as auto-correlation and factor analysis to
identify the risk factors relevant to each segment of their portfolio.
Banks also need to have in place, methodologies to stress each of the risk measures.
The complexity of these methodologies will depend on the nature of the variable
being stressed and would, in general, involve use of statistical techniques.

CONCLUSION

Enabling enterprise-wide stress testing would require evolved technology solutions
that can couple data management capabilities with complex computations required
to stress wide variety of risk measures using multiple scenarios.
Stress testing approaches and regulatory requirements are going to evolve rapidly.
Banks will require technology solutions that are extensible and are able to provide a
central environment that can “host” models existing in different silo’s of the
organization and stress them in a holistic manner. These solutions need to enable
senior management to take strategic decisions on capital management & business
planning by providing extensive capabilities on enterprise-wide stress testing.
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A Practical and Holistic Approach to Stress Testing in Financial Services : Strategies for Success
September, 2009
Author: Oracle Financial Services


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