1. +Stress Testing: Understanding what is Required fromRegulators in Current and Future LegislationBarry Schachter

2. +Plan of the TalkScope of stress testing requirementsWhos affected and whenRequirements under different rules CCAR Dodd-Frank Supervisory Guidance SR 12-7 3. +Whos Subject to Stress Test Rules?Supervisory Guidance (SR 12-7): Financial HCos., Banks, S&Ls >$10 billion assetsDodd-Frank (section 165):FinancialHCos., Banks, S&Ls, SIFIs>$10 billion assetsCCAR:Bank HCos.>$100 billion assets 4. +Sorting out CCAR and D-F Dodd-Frank (Sect. 165) Annual supervisory stress testing for SIFIs, includes Banks>$50Bin assets Annual company-run stress testing for Banks and Financial HCos.>$10B in assets Semi-annual company-run stress testing if >$50B in assets Company-run scenarios must include a severely adverse scenario Minimum of three supervisory scenarios required: Baseline,Adverse, Severely Adverse Mandates public disclosure of results CCAR Annual supervisory severe adverse stress test for large, complexbank HCos., >$100B in assets originally, now >$50B 5. +Number of Affected Firmsas of Q3 2012120100 Bank HoldCos > $100B 80 Fin HoldCos >$10B 60 *Fin HoldCos >$50B 40 Banks & S&Ls >$10B 20SIFIs0 CategoriesSource: FFIEC, FDIC, Federal Reserve 6. +Whos In the 2012-2013 Cycle?CCAR 19 7. +Whos In the 2012-2013 Cycle?CapPR 11Other US BHCs>$50B in Assets 8. +D-F/CCAR Stress Testing CycleNovemberOctober 1 January 5 March15 15Fed & Banks Fed RunsBiggestPublicBanks Run Own Tests BanksReportingDevelop Scenarios AnalyzesMid-cycleof ResultsScenarios Capital Process 9. +Stress Test Creation Supervisory Scenarios begin with economic shocks to 26 (for2012-2013) macroeconomic variables The stress test must then translate these into their impact onvarious categories of income and expense, and Flow those impacts through to net income on a quarterlybasis, which Combined with forecast changes in the capital account, areused to estimate impact on regulatory capital Trading books are subject to an instantaneous shock asspecified by the supervisor 10. +Macroeconomic Shocks 2013 Supervisory Scenarios 2012-2013DJ Total Stock Market 20000 18000 16000 14000 12000 11042.3 1000080007221.7600040002000 0 11. +Severely Adverse Market ShocksEquity by Geography 0%-15% New ZealandSwitzerland United KingdomChileSweden Mexico Philippines Turkey-30% GermanyMalaysia AustraliaEuro Stoxx 50India United States Poland SouthMSCI EAFE Africa Stoxx Europe 600South Korea FranceJapanChina Hong Kong MSCI World Index Belgium Finland MSCI All CountryCanada-45% Denmark Hungary Czech Republic Brazil Taiwan WorldIndex Index Netherlands Indonesia Singapore Israel (ACWI) GreeceArgentina MSCI EM Index Italy NorwayMSCI EMEA-60% Austria MSCI EM LatinIndexSpainAmerica IndexBulgaria-75% RussiaIrelandPortugal Ukraine, -84.30%-90% 12. +From economic shocks to gains andlosses Crucial!Two ways to go: simulation historical relationshipSee, e.g., CCAR 2012: Methodology and Results for Stress ScenarioProjections, Appendix A 13. +Stress Testing under CCAR & D-F The details 9 quarter horizon, instantaneous shock for trading books As-of dates 9/30 (and 3/31) for annual (mid-cycle) tests Random end-Q4 as-of date for trading books Implementation decisions Interpolation, extrapolation, proxying shocks Bank baseline scenario adopt supervisory baseline? Models dont work with shocks Documentation Must use standard templates must document and justify deviations 14. +Disclosure From banks to the supervisor FR Y-14M (and 14A and 14Q) From the supervisor to the public Details of economic and market shocks Using both D-F and bank capital plan assumptions, lowest quarterlyand end of forecast horizon capital ratios, severe adverse scenario Using D-F capital plan assumptions, time-aggregated netrevenue, loan losses (by type), trading and counterparty creditlosses, net income 15. +Disclosure FromBanks to the public types of risks included in the stress test; description of scenarios developed by the company, including key variables used (such as GDP, unemployment rate, housing prices); description of the methodologies to estimate losses, revenues, and changes in capital; and aggregate losses, pre-provision net revenue, allowance for loan losses, net income, and pro forma capital levels and capital ratios over the planning horizon under each scenario. 16. +Reverse Stress Testing New concept for banks FSA (UK) leading in requiring this Regulators like it but are silent on method 17. +Reverse Stress Testing Defined assume a known adverse outcome then deduce the types of events that could lead to such an outcome. (Federal Reserve Board SR 12- 7, p. 12) Sounds simple, but 18. +Reverse Stress Testing History FSA FSABIS Principles USProposed RequirementsCRMPG III for Sound UK banks goSupervisoryRules Formalized 2008-08Stress Testinglive 2011-12Guidance(CP08/24) (PS09/20) 2009-052012-11 2008-12 2010-12 19. +Reverse Stress Testing IllustrationMirzai & Mller. 2013. On Reverse Stress Testing. Intelligent Risk, 8-11. Pick critical loss level(CLL) Obtain 30K samples fromjoint distribution of riskfactor returns Revalue portfolio 30K times Onlylook at those sampleswhere portfolio loss > CLLBy CaitlinJo [CC-BY-3.0(http://creativecommons.org/licenses/by/3.0)], via Wikimedia Commons 20. +Reverse Stress Testing IllustrationMirzai & Mller. 2013. On Reverse Stress Testing. Intelligent Risk, 8-11. Can we find economic meaning inthese large loss samples? First,look for statistical commonalities using k-means clustering Second, relate cluster behavior to market risk factorsthrough heuristic analysis 21. +Reverse Stress Testing IllustrationMirzai & Mller. 2013. On Reverse Stress Testing. Intelligent Risk, 8-11. 22. +Reverse Stress TestingIn sum: immature artRecent research collected at www.Gloria-Mundi.com;search on keyword phrase reverse stress. 23. +