Stress Testing October 06 London Presentation

8/9/2019 Stress Testing October 06 London Presentation

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Stress testing and scenario analysis in

risk management

By

David Brawn and Alan Cathcart

Risk Review Department

Financial Services Authority

Presentation to

PRMIA Seminar25 October 2006


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Outline of talk

A. Introduction

B. Stress testing and risk management

C. Stress testing and regulation

D. Stress testing under Pillar 2

E. Thematic Review

F. Conclusions


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What is stress testing?

Two varieties

Sensitivity analysis (or single-factor

tests) - identifying how portfolios respond

to shifts in relevant economic variables or

risk parameters;

Scenarios - assessing the resilience of

financial institutions and the financial

system to severe but plausible scenarios


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B. Stress testing and risk management

What is covered by risk management?

Day to day risk management

Business planning

Capital planning

Strategy-setting

Programme of stress testing

Firm- or group-wide scenarios

Range of more static stress tests

Business unit stress testing Market risk or credit risk stress tests

Ad hoc stress tests


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How does stress testing help?

Complements other risk management techniques

Sanity check

Reduced reliance on model parameters e.g. historicalcorrelations

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

Broad perspective

Portfolio or business wide perspective

Multiple horizons - sometimes instantaneous, sometimesyears ahead

Transparency Management action visible

Intuitive, easy to understand


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Stress testing more than just a tool

Stress testing assists senior

management:

Assessing their view of risks

Identifying risk concentrations

Focussing on severe but plausible events

Taking or planning mitigating action


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C. Stress testing and regulation

Regulatory attitude to stress testing

Strongly in favour

Emphasis on role of stress testing inmanagement of business

Stress testing being written into regulatory

rules

But Very little prescription from regulators


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Why should this be?

Financial regulation is forward-looking

Focuses on adequacy of financial resources:

capital, liquidity, etc.

Events which threaten objectives of consumer

protection and market confidence

Inability of regulators to monitor firmsexposures in detail

Reliance on senior management of firms Stress testing needs to be proportionate and

adapted to the firm in question


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FSA stress testing requirements

FSAs stress testing requirements derivefrom our Principles for Businesses

Principle 3

a firm must take reasonable care to organise and controlits affairs responsibly and effectively, with adequaterisk management systems

Principle 4a firm must maintain adequate financial resources

Stress testing requirements also come fromBasel, the CAD and the CRD


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FSA stress testing requirements

Market risk (Basel market risk

amendment and CAD)

Credit risk (Basel 2 and the CRD)

Pillar 2 and GENPRU

Liquidity


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Pillar 1 Market Risk

Why?

Qualitative or Quantitative?

Stress Test Design

Prescriptive or not?


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Why a Pillar 1 requirement?

Only for VaR based capital

Regulatory VaR

Short Horizon/Liquid Markets

Extreme tail of distribution

Completeness Regulatory Tinkering


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Horizon/Liquidity Issues

Implicit in parametric models

Historic Simulation memory

How exposed are you to changes?

Liquidity Adjusted VaR is complex


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VaR is a measure of risk in the tail

In large portfolios correlation is

dominant

Have we correctly parameterised?

Do we have sufficient data in His Sim?


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Absent Risk Factors

Insufficient Data

Computational tractability

Scenarios/Stresses used to generate

capital requirement


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Regulatory Tinkering

Two adjustments from VaR to capital

60 day averaging

Multiplication by 3

What is the final outcome?


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Qualitative or Quantitative?

Qualitative

Supplementary management information

Challenge to VaR

Good measure of risk polarisation

Quantitative Risks not captured in VaR


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Stress Test Design

The hardest question!

Severe but plausible

Historical versus prospective scenario

Bottom up (Whats the worst thing.)

Whos responsibility?

Senior Management involvement iscritical.


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Prescriptive or not?

At this point the answer should be

obvious!

Effective stress testing should be: Position Sensitive

Market Condition Sensitive

Business Development Sensitive


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FSA and stress testing

In 2005, two industry workshops, a

Discussion Paper and a Feedback

statement FSA Discussion Paper 05/2 Stress

Testing, May 2005

FSA Feedback Statement 05/02 Stress

Testing: Feedback on DP05/2,

December 2005


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Comprehensive Approach

In DP 05/2

Six characteristics for an effective stress testing

programme

Developed with the industry, not FSA guidance

FS 05/2

we shall expect to see all firms, particularly the

larger and more complex institutions move

towards incorporating the principles of theComprehensive Approach within their risk

management systems


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Comprehensive approach (contd)

1. Senior management will beable to identify and articulate afirm's risk appetite andunderstand the implications ofstress events within thiscontext.

2. Senior management will takean active part in identifyingpotential stress scenarios.

3. Outputs from stress testing willbe communicated to seniormanagement in

comprehensible format.

4. Senior management will havean overview of firm-wide risksand stresses and a concept oftotal risk even where preciseaggregation is not possible.

5. Senior management willconsider formally theimplications of stress testing fora firm's strategy or businessprofile.

6. IT systems, resources andprocedures will allow senior

management to identify,quantify and manage efficientlythe stresses that affect a group.


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D. Stress testing under Pillar 2


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Objective:

That the firm can meet its capital requirements at all timesthrough out a reasonably severe economic recession.

Why capital planning?

Not only interested in adequacy of capital today

Want to be sure that firms will hold sufficient capital in thefuture

Two aspects:

Capital planning; and

Stress testing.

Capital planning and stress testing


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Stress tests should be all

encompassing

Stress tests should be all encompassing and primarily cover: Credit risk

Market risk

Operational risk

It will be also important for firms to consider second-order

impacts: Changes to portfolio concentration levels

Reputation (to the extent that the stress event is name specific)

Impact on availability of liquidity sources


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Yr 1 Yr 2 Yr 3 Yr 4 Yr 5

CRR

time

Capital

Base case (how do management expect the businessto develop)

Additional capital needed

as the business grows

Capital generated asbusiness grows


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CRR

time

Capital

In severe stressed case (pre management actions)

Capital

deficit

Firm makes losses


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CRR

time

Capital (post)

In severe stressed case (post management actions)

Cut dividends

Reduced costs

Raised extra capital

(eg share issue)

Reduced business volumes

Capital (pre)


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Capital for future needs Projected CRR under stressed scenario

Plus;

Losses;

Dividends

Other appropriations

Minus

Profits;

New capital raised (eg share issue)

Other management actions (eg cut costs)



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Challenges Realistic base case

An appropriately severe stress test

Credible management actions



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E. Thematic Review


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Thematic Review in 2006

Sample of ten large financial firms in the banking,building society and investment firm sectors. Visitedfirms in Q2 and Q3.

Objectives:

Review of good practice

Assessment against the characteristics of the

Comprehensive Approach

Dear CEO letter sent to chief executives on 9th October,published on FSA website on 16th October. Link:http://www.fsa.gov.uk/pubs/ceo/stress_testing.pdf
http://www.fsa.gov.uk/pubs/ceo/stress_testing.pdfhttp://www.fsa.gov.uk/pubs/ceo/stress_testing.pdfhttp://www.fsa.gov.uk/pubs/ceo/stress_testing.pdf


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Thematic review - results

We saw a range of activity, with

developments and improvements under way,

but scope for further progress

Some issues

Senior management engagement

Severity of stress events

Effectiveness of presentation and communication

Challenge or confirming business assumptions


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Key findings Close engagement by senior

management resulted in themost effective stress testingpractices.

Good practice was observedwhere firms conducted firm-wide stress tests of scenarioswhich were plausible, yetunder which profitability wasseriously challenged, keybusiness planning

assumptions were flexed orscope for mitigating action wasconstrained.

Communicating results clearlyand accessibly was importantfor many firms

Good practice entailed usinggroup-wide stress testing andscenario analysis to challengebusiness planningassumptions


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F. Conclusions

Stress testing valued by industry andregulators alike

Scope for progress within firms

Pillar 1 and Pillar 2 requirements arechallenging

Dear CEO letter was published in October2006

Continued focus on stress testing by FSA

Stress testing can help reduce risk in thefinancial system

Stress Testing October 06 London Presentation

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