Stress Testing – evolution for high-level risk management

In the last ten years financial institutions have experienced an evolution of their stress testing activities, strongly influenced by regulatory pressure. More recently, it has become necessary to incorporate these activities into the decision-making process and thus potentially generate additional value.

REGULATION

Since 2009 bank regulations have, among other things, led to an intensification of the requirements on banks’ stress testing programs. The aim was to create a common understanding of the requirements for stress testing within risk management, and to introduce best practices and thinking patterns among bank managers (as well as senior management and board members) to further develop internal stress testing frameworks. In the long run, improved stress testing programs signal stable and well-managed institutions with solid risk governance and adequate risk-bearing capacity. However, after almost 10 years of development, the current implementation status still offers much room for improvement, especially where IT infrastructure, data quality and governance frameworks are concerned.

INDUSTRY

The perspective of the financial institutions is shifting more and more from mere fulfillment of regulatory requirements to using stress testing for value-adding purposes on management level. The development of stress testing capacities typically involves different units within the banking organization. The need for improved efficiency and performance in conducting stress tests has challenged banks to integrate their silos and existing parallel processes more consistently across the different risk types and departments. At a methodological level, banks are currently faced with the task of defining severe but plausible scenarios. The greatest methodological challenge is the estimation of the dependencies between models and parameters. These must also be economically justified and modellable in the IT systems, to ensure that possible correlations and diversification effects can be taken into account as realistically as possible.

SOLUTION

Every institution should have a clear picture of the status of its stress testing framework, respective the business needs and the supervisory expectations. With the help of a gap analysis, possible deficiencies can be identified and categorized based on predefined dimensions and criteria. The results of such an analysis provide valuable input for decisions regarding development needs and future action plans.

In general, there are three main implementation areas for future projects.

The internal processes of the institutions should facilitate the proper functioning of the stress testing activities through solid governance and organizational structure. The second area of implementation refers to the methodology used for economical and mathematical justification. Specifying relevant inputs for the stress scenarios and their rollout under arbitrary assumptions is a knowledge- and time-intensive process. By using a Challenger Model, any deficiencies in the deployed methodologies regarding inputs, calculation logic and results can be easily validated and their quality assured. This increases the accuracy of the stress test results while decreasing the model risk.

The third implementation area covers the technology used to provide and process the data for the purpose of stress testing. Ultimately, the key to a successful stress testing framework lies in adequate IT infrastructure and data governance. It is therefore fundamental to have well-functioning systems and technologies for handling large data sets, which allow for complex calculations and reconciliation of data across the organization.

The internal benefits of stress testing activities can be only realized if the relevant stakeholders understand, challenge and use the information generated through the process when making strategic and operative decisions. By developing relevant training programs at every level of the organization, institutions can establish and develop internal expertise on stress testing.

VALUE ADDED

The main added value offered by stress tests is that the institution gains comprehensive insights and guidelines for its risk strategy and the entire management of the bank. When managers are in a position to make well-informed decisions based on accurate stress test results, this not only ensures the economic and financial survival of the bank but can also allow for profitable performance during a crisis.