60096255 ernst and young stress testing

8/12/2019 60096255 Ernst and Young Stress Testing

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Stress TestingChallenge yourself before being challenged


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Stress Testing Ernst& Young 2009

Table of Contents

1. Current developments 4

2. Critical steps in developing a stress testing 8framework

3. Relevant questions to consider 11

4. Establishing and enhancing a stress testing 12framework in practice


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3Stress Testing Ernst& Young 2009

Amidst a lack of condence in existing projections and risk metrics,the recent global market turmoil has raised unprecedented levels ofinterest from industry and regulators in stress testing methods andresults:

The size of losses incurred by banks and the succession of newwrite-downs each quarter has obliged nancial institutions todrop their usual business forecasting and in some cases, to as-sess whether they would still be going concerns once the crisisbottomed out.

Other risk measurement tools, such as value at risk and econom-ic capital, which were based on assumptions of distributions,have proven to be too optimistic and inaccurate until signicantrecalibration is performed.

The importance of stress testing as a core component of risk man-agement has been emphasized in the ICAAP (Internal CapitalAdequacy Assessment Process) 1 requirements under Pillar II ofBasel II and supervisors in many countries are looking to banks toimprove the techniques and comprehensiveness of these tests go-ing forward. Given the strains across the nancial markets, variouscentral banks and regulators have also enforced the participation ofbanks in system-wide stress testing. In Switzerland, the FINMA car-ried out a stress testing exercise in summer 2009 with a dedicatedsample of banks. The tests were designed to assess whether banksrequire additional capital to maintain a well-capitalized regulatorycapital status and to gain condence in the stability of the localbanking market.

Editorial

The current Swiss regulation does not require banks to conductstress testing at a portfolio or bank-wide level. However, mostbanks anticipate more regulatory scrutiny on linking stress testingto capital planning. Board members and the senior management ofbanks are placing increasing emphasis on internal stress tests forselected areas on a periodical basis and consequently, are set toplay a more signicant part in appraising and challenging stresstesting results.

The aim of this brochure is to give an overview of the critical steps

towards a bank-wide integrated stress testing framework and to of-fer hands-on implementation guidance. Discussing the stress test-ing topic with our clients, we learned that most banks prefer toadopt a reliable yet pragmatic approach that for reasons of costmanagement and reduction of complexity starts from existingprocesses and stress testing elements and gradually extends to afully-edged and sophisticated model including all Pillar II risks.We are condent that this brochure will give you a good overviewof all relevant issues and that it will help you adopt a pragmaticapproach to stress testing within your organization.

1 Bankfor International Settlements: Principles for soundstress testing practicesandsupervision, May 2009.

Dr. Marc RyserPartner+41 (0)58 289 [email protected]

Daniel MartinSenior Manager+41 (0)58 289 [email protected]


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4 Stress Testing Ernst& Young 2009

Disclosure: striking a balance

There is a consensus in Europe on the importance of stress testingbut not on the release of results. Whereas US agencies released re-sults of individual institutions, Switzerland and the EU have not dis-closed the names of the banks that were tested. The US disclosedresults to help restore condence in the market but Switzerland andthe EU took the stance that by singling out an individual institutionsrisks, their access to capital is compromised. Other issues need tobe addressed to allow meaningful disclosure of stress tests. First,the choice of scenarios, and especially the severity and likeliness ofthe scenarios, should be clearly explained to avoid misinterpreta-tion. There have been criticisms about the recent exercises that thedened adverse scenarios were actually close to revised economicexpectations by the time the stress tests were completed.Information on the methods and measures of impact (on earnings,capital, liquidity), as well as error margins, must be sufcient toallow comparison of the results over time and across institutions.Finally, if market participants come to rely on stress test results asan indication that a bank is a going concern, disclosure by the bankswill require assurance on the reliability of the calculation, through

an independent audit.

From testing individual risks to fullbalance-sheet modeling

The focus on banks making stress testing a core part of the controlframework will continue. The Basel Committee denes a stress testas the evaluation of a banks nancial position under a severe butplausible scenario to assist in decision-making within the bank. Theterm stress testing is also used to refer not only to the mechanicsof applying specic individual tests, but also to the wider environ-

ment within which the tests are developed, evaluated and usedwithin the decision-making process. 2

The techniques most widely referred to as stress testing can bedescribed as follows:

1. Current developments

2 Bank for International Settlements: Principles for soundstress testing practicesandsupervision,May 2009.


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Sensitivity analysis which assesses the resulting impact of changesin the models parameters. For example, Basel II requires the cal-culation of the impact on interest rate risk of a 200 basis pointshift in interest rates. It is also a standard procedure for modelvalidation, which assesses the range of inputs for which modelperformance remains reasonable.

Scenario analysis can use a historical crisis and apply it to therms current or projected position. Useful when a historical sce-nario could re-occur, or is of an appropriate indicative magnitude,its use is, however, limited when specic events are not applica-ble or severe enough to impact the rm, or when there are nosuitable historical events for specic risks (as was the case withthe current credit crisis).

Hypothetical scenarios are typically used for extreme tailevents, where data is sparse or not available. Used by many rmsduring overall capital adequacy assessments, the techniqueallows evaluation of events that are plausible but challenging tomodel. These hypothetical scenarios use a mixture of elementsincluding shocks seen for parts of the portfolio in previous

events, mixed with other purely hypothetical stress elements tocover the current prole of the portfolio.

Reverse stress testing is used to demonstrate the strength of arms capital position by identifying (1) the severity of thescenarios needed for the rm to fail, or (2) events and develop-ments causing losses which exceed a given level. The FSArequires all banks to carry out reverse stress testing to focusattention on the combination of events which would put a severestrain on the bank. The results then need to inuence decisionson capital, mitigating actions and strategy.

These techniques have been applied to varying extent across thedifferent major risk types:

Market risk stress testing has been an established technique formany years, with the application of both historical and hypotheti-

cal scenarios and development by advanced banks of multi-factoranalyses.

Credit risk advances in stress testing have largely followed theimplementation of internal rating systems to meet Basel II. Banksare working on methods to project forward arrears rates and lossgiven default for different portfolios. Stress testing of counter-party credit risk continues to be an area of methodologicaldevelopment at banks using advanced potential future exposuremodels. In the current environment stress testing of structuredproducts often actually amounts to a line-by-line credit review.Under Basel II the banks also face issues regarding procyclicalcapital requirements (i.e. requirements which rise in a downturnand fall in a boom). Banks are required under Pillar II to assesshow far capital requirements could rise and are developing arange of techniques to do this.

Operational risk scenario analysis is a key componentof Basel IIs advanced framework but the sophistication ofapproaches varies.

Liquidity risk many banks are now conducting scenario analysesas a result of the recent market events.

Banks in various countries have had to develop the rm-wide,cross-risk capabilities required for the assessment of the overallrisks faced by the rm and the capital required to meet the ICAAPrequirements under Basel II. Unlike our neighboring countries, sofar Switzerland has not introduced any concrete ICAAP directives.Nevertheless, based on the aforementioned developments andthe stress testing and review activities currently being performedby FINMA in the Swiss market, it can be anticipated that morestringent requirements may follow and, eventually, that capital

requirement levels may rise.

One type of new approach is balance sheet modelling. Such anexercise can be summarized as a full modeling of the balance sheetunder adverse conditions or a stressed version of the business plan.


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Figure 1: Insights and recommendations

Linkage of stress testing with strategy process and risk appetite Critical challengeof stress testing methodology and results

Goal and target measures Roles and responsibilities Assumptions, methodology, frequency and coverage Limits and escalation procedures Risk mitigationand contingency planning for stress testing results Documentation and reporting of results Regular validation of methodology and (re-)approval of policy

Exposure aggregation (risk factor, product, counterparty) Fast andefcient adaptationand creation of new scenarios Targetedand ad-hoc stress tests

Combined effects (systemwide, intra and inter-risk factor interactions and causalities) Broader coverage of target measures: bank wide P&L andeconomic capital,

liquidity & funding, viability of business model Broader coverage of scenarios: ad hocscenarios and integration of specic risks,

reverse stress tests

More involvement ofBoD and top management

Bank-widestress testing policy

Robust andexible stress testinginfrastructure

Bank-wide focus onscenarios and targetmeasures

Recommendations

This requires a stressed projection of credit provisions and tradinglosses, and a challenge to redemption forecasts, forecasting oftreasury assets and hedging, and assumptions on income and thecost base, including tax rate. Rigorous analysis means that few P&Litems can be left unchanged. For example, effective tax rates havemoved signicantly in the current economic environment. Adjusting

variables through stress testing may have the effect of changingthe nature of tax assets; for example, from current to deferred,which is likely to have consequences for capital adequacy. It alsomeans that the tax rate for testing purposes may not be theaccounting tax rate.

Insights and lessons learned

Although stress testing is basically not a new discipline, stress test-ing solutions and approaches are still in a developing phase. In lightof their developing nature and due to the current market turmoil,various regulatory bodies conducted in-depth analysis of presently

applied stress testing procedures (BIS Jan 09, FSA Dez 08, IIF Jul08, FSF Apr 08).

Figure 1 provides an overview of the most crucial insights: It is theclear view of both national and supra-national regulatory bodiesthat current solution have to be enhanced and strengthened.The elds outlined above will be a particular focus and we expectincreased scrutiny on these. As such, rms are well advised to takethese aspects into consideration when engaging in stress testingprojects.


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Present techniques and currentviews must be challenged inlight of a fundamentally changingenvironment.


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Supervisory exercises conducted in various countries showed thatmany institutions lacked an efcient rm-wide stress testing frame-work. Indeed, several supervisors had to extend their original dead-lines from a few weeks to several months, to grant banks the timeto deliver the results.

It is apparent that rm-wide stress testing is still a highly manualprocess with signicant coordination needed to align assumptionsand the projection process between risk, nance, treasury and busi-ness units. A clearly integrated approach and infrastructure is alsorequired to efciently aggregate estimates from multiple modelsand link balance sheet and income dependencies. Consistent fore-casting models are not typically in place for all balance sheet andincome statement categories to support integrated projections.

Modeling capabilities vary across institutions and portfolio types.The most sophisticated banks have developed macro-economic,factor-driven loss forecasting models. Other institutions withoutthese modeling capabilities used more pragmatic approaches basedon historical loss rates, supplemented by expert judgment andbenchmarks.

Many existing nancial forecast models lack sufcient risk granu-larity to readily support integrated income and loss forecasting.Beyond market, credit riskand net interest margin, few approachesor established processes exist to robustly project losses and incomestatement effects under alternative scenarios to existing baselineforecasts.

Many institutions have encountered data quality, reconciliation anddata management issues as they set up models, ran the projectionsand tried to aggregate across categories.

Given the current unprecedented environment, solutions thatextrapolate from historical data need to be carefully complementedwith management expertise and hands-on business knowledge;stress tests require signicant management involvement to inter-pret scenarios, approve assumptions, and business strategies, andanalyze offsetting or compounding risk effects.

2. Critical steps indeveloping a stresstesting framework


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Under the Pillar II/ICAAP requirements, presently not implementedin Switzerland, institutions need to have a repeatable process forsimilar scenario analyses, rather than relying on ad hoc solutions.This requires the following critical steps:

1. Analyze and dene the approac hThe scope of a stress testing program must be determined riskcoverage, risk prole/materiality, and required outputs andreporting granularity. A review of existing stress testing capabilitiesshould be performed against these objectives. To establish projec-tion methodologies that link risk and nance model inputs to macro-economic factors requires an understanding of the specic riskdrivers within portfolios and their impact on nancial metrics andportfolio performance. It is also important to estimate the time be-tween the initial economic shock and the impact on the banks -nancial situation (the lagged effect). Stress testing must be inte-grated into the risk management framework/risk governance anddecision-making at the appropriate level of seniority.

2. Choose appropriate scenariosFor stress testing to effectively support senior management

decisions, the number of scenarios must be kept to a handful to bemanageable, while still providing a thorough assessment of risk.Relevant scenarios must be selected from adverse variations tothe plan, using the same type of indicators as for baseline businessplanning and additional scenarios, given the institutions risksensitivities.

Scenarios must then be translated into factors that drive risk andnance models, developing a set of parameters for each scenarioto stress the key income statement and balance sheet metrics thatmeasure the banks solvency and liquidity position. Data require-ments must be dened and assumptions around new business and

risk proles under each scenario have to be established. For largerinstitutions, the key challenge is to apply consistent scenario inter-pretations across multiple risk and nancial statement models, anddesign stress testing capabilities at different levels (e.g., bank-wide,business unit, business line).

3. Build a repeatable processExecution of the assessment must take place within a clearlydened and repeatable process. The process must cover the gath-ering of required data, addressing cases where it may be scarce andlacking in quality. The application of stress testing solutions mustbe supported by the development of an adequate infrastructure.Process planning must allow for expert judgment review sessionsand workshops where needed. Such an integrated process canrequire establishing additional governance as applicable, eitherthrough a distinct stress testing committee involving senior riskand nance representatives, or through integration with capitalplanning committees. Activities must be documented to supportinternal analysis and supervisory dialog.

4. Aggregate, report and review resultsThis was perhaps the step that many institutions found mostchallenging during supervisory exercises.

Within a short time frame, institutions must run aggregation ofnancial model and capital projections and produce managementreports explanatory diagnostics, sensitivities, key behavioral

assumptions.

The results must be reviewed to challenge behavioral assumptionsand, if appropriate, calculations may need to be re-run. Theresults should be reported to senior management to determinetheir action regarding capital adequacy strategy and risk manage-ment, including potential revision to the business plan. For stresstest results to support decision-making within large institutions,the calculation and reporting process must provide for appropri-ate controls and timely delivery of information. One approachcould be to implement stress testing within the yearly budgetprocess. To ensure necessary management involvement within

businesses, lines, this process must provide relevant businessinformation. This can be achieved by including not only scenariosinvolving severe but rare events, but also sensitivity analysisof business to potential adverse conditions that could causeoperating income to become negative.


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Strenuous training and soundpreparation clear the way for astable and more predictablefuture.


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The stress testing framework applied should ideally reect thestructure, complexity and business scope of a bank. As such, astress testing framework does not per se need to be highly complexand overly expensive. However, certain elementary componentshave to be taken into consideration.

Scope

First and foremost, a bank has to form an understanding of thescope of stress testing to be applied. As explained above, stresstesting is a generic term summarizing various techniques and notall of them are applicable to a specic bank. Figure 2 provides anoverview of the presently observed techniques applied.

A bank will have to identify what means of stress tests it is currentlyapplying and in which direction it would like to develop its capabili-ties. Often, lower level and operational stress tests are already im-plemented in certain risk silos, such as short horizon stressing ofmarket risk factors in the trading or banking book (these may evenconstitute regulatory requirements for some banks). Aligning and

aggregating these silo-based stress tests in a simple way offers apragmatic rst step. Later, banks usually start developing broader,macroeconomic scenarios and linking them to various risk typesand eventually bank-wide target measures, hence commencing withPillar II stress tests. First versions of bank-wide Pillar II stress testsare often based on expert judgment and limited statistical analysis.During later enhancements, analytical ties amongst the macro-economic scenarios and the risk drivers may be extended andstrengthened.

Stress testing process

Stress testing is an endeavor that is too extensive to be conductedonly once or on an ad hoc basis. To the contrary, many institutionsdecided in line with regulatory requirements to have the calcula-tions conducted on a regular, often quarterly basis, ensuring contin-uous oversight of the stress exposures.

4. Establishing andenhancing a stress testingframework in practice


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Figure 3 on the following page shows an example of such a stresstesting process.

Stress testing usually starts with the denition of the relevant sce-nario input parameters and assumptions. Such parameters are thenlinked either statistically or based on expert knowledge to port-

folio specic risk factors. In the case of a macroeconomic scenario,for instance, historically observed changes in GDP would be linkedto the observed development of PD grades per segment, move-ments in house price indices would translate into Loan-to-Value andLGD effects. Once such relationships are estimated and established,they can then be used to project resulting losses from hypotheticaleconomic scenarios. This process can be repeated with various

Figure 2: Stress testing landscape

Standard scenario set

Historic worst orsensitivity-based

Backward-looking

Current risk factors

Ad hoc scenario set

Targeted to specicpositions

Backward or forward-looking

Specic risk factors in timesof stress

(Macro-)economicscenario set

Calibrated to bankspositions

Forward-looking Current risk factormoves, derived from macro-economic variables

Out of the boxScenario set

Reverse stress testing Forward looking

Current & complementaryrisk factors

Viability of banks,business model

Liquidityandfunding gaps

Bank-wide P&L andeconomic capital

Bank-wide P&L andregulatory capital

Business line P&L

Position values

Post-crisis stress testing

Pre-crisis stress testing

Pillar I stress testing

Scenario sets

Target measures

scenarios in order to test the loss potential under varyingconditions, helping the bank identify the instances that are mostcrucial to its existence and future prospects.

A further important aspect is the challenge to conducted calcula-tions by experienced risk professionals. It is not the notion of stress

testing to replace one mathematical black box with another!On the contrary, the results generated as well as the techniquesleading to these results should be straightforward to communicateand uncomplicated to comprehend. As such, seasoned risk profes-sionals should validate and challenge both the assumptions andresults from stress tests. Often this is conducted by a stress testingcommittee.


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Limitation

Finally, the results reviewed and approved by the committee arereported to the Executive Management and the Board of Directors.

Based on the insights gathered, the banks governing bodies mayadjust their risk appetite or initiate other means of correctiveaction. However, it is important in this context that a sound set ofstress limits are in place. These limits help the bank to reduce itsloss potential and ensure that the maximum losses are in line withthe banks risk appetite. Such limits are usually reviewed onceper year more often in the case of unusual developments suchas changes in the scope of business or drastic macroeconomicdevelopments and approved by the banks governing bodies.

Figure 3: Stress testing process

Scenario denition

Scenario 1: Global recession and consumer retrenchment the GDP in the USA goes down by 3% (each year within two years) the GDP in Europe goes down by 4% (each year within two years) the interest rates in the USA go down to 0% the interest rates in Europe go down to 0.25% the stock market in the USA goes down by 45% (within two years) the stock market in Europe goes down by 35%(within two years) the stock market in the BRIC countries goes down by 15%

(within two years)

Scenario 2:

Stress test result analysis and actions

Stress test result analysis and actions Limits Risk capacity and risk appetite Regulatory and economic capital planning Risk identication

Regular committeemeeting

Bank-wide stress loss

Input parameters (overallassumptions) GDP, IR

Stress test model(regression )

Output parametersPD, FX

Sensitivitiesbusiness line 2

Aggregation

Sensitivitiesbusiness line

Sensitivitiesbusiness line 1

Macroeconomic timesseries

Stress test report

Stress test model


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Executive summary

This brochure outlines the current developments in the eld ofstress testing and their respective importance for banks manage-ment. Beyond regulatory pressure, the economic added value of asound stress testing framework is signicant and initial pragmaticresults can be obtained with reasonable efforts.

Internationally, detailed guidance on single risk and rm-widestress testing is evolving. At the moment, the available regulatoryguidance is still rather principle-based. However, as attention onthese areas intensies, more concrete standards are expected toevolve.

Due to the continued economic uncertainty, volatility of earningsand evolving capital regulations, rm-wide stress testing alsorepresents a critical management information tool to supplementexisting standalone nancial and risk metrics. Developing asophisticated stress testing framework, however, is a multi-yeareffort requiring management direction and infrastructure invest-ment, with clear denition and prioritization of activities.

Ernst & Young has successfully completed a large number of stresstesting implementation and review projects with a variety of banksboth nationally and internationally. As such, Ernst & Young iswell placed to advise any bank that is reecting on its stress testingstrategy, is in need of concrete stress testing solutions, or wouldlike to compare its present approaches against current marketpractice standards.


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