macro-prudential policy and financial stability: issues and challenges 16-18 december 2013...
TRANSCRIPT
Macro-Prudential Policy and Financial Stability:
Issues and Challenges16-18 December 2013
Intercontinental HotelAmman, Jordan
Stress Testing Banks and Financial Institutions
• Good practices• Stress testing models and scenarios• Practical considerations
Mr. Keith PooleyMETAC Banking Supervision Technical Expert
The importance of stress testing“Stress testing plays an important role in:
providing forward-looking assessments of risk;
overcoming limitations of models and historical data;
supporting internal and external communication;
feeding into capital and liquidity planning procedures;
informing the setting of a banks’ risk tolerance;
and facilitating the development of risk mitigation or contingency plans across a range of stressed conditions.”
Stress Testing and Risk Governance“Stress testing should form an integral part of the overall governance and risk management culture of the bank.
Stress testing should be actionable, with the results from stress testing analyses impacting decision making at the appropriate management level, including strategic business decisions of the board and senior management.
Board and senior management involvement in the stress testing programme is essential for its effective operation.”
Stress Testing and Capital Plans
“Supervisors should consider the results of sensitivity analyses and stress tests conducted by the institution and how these results relate to capital plans.” 3
GOOD PRACTICESWHAT DOES BASEL SAY ABOUT STRESS TESTING?
STRESS TESTING GOOD PRACTICES
The following slide provides an example of good practice in relation to the Governance Framework
The process is Board-led, with the Board: proposing some of the scenarios to be
run challenging approaches, scenarios and
outputs approving approaches, scenarios and
outputs receiving sufficient training to support
these objectives
GOOD PRACTICES - GOVERNANCE
Under leading practice, stress testing needs a set of governance arrangements driven primarily by the Board and an integrated operating framework.
Board and senior management engagement
Clear responsibilities, allocated resources, and written policies and procedures
Embedded into risk management processes and supported with an appropriate risk infrastructure
GOVERNANCE FRAMEWORK
Outputs are actionable and inform strategic
decision making
Governance of stress testing and use
Regular review of programme to assess its
effectiveness
GOOD PRACTICES – OPERATING FRAMEWORK
The following slide provides an example of good practice in relation to the accompanying Operating FrameworkThe framework encompasses: macroeconomic stress tests, scenario / ‘what-if’ analysis and sensitivity
analysis - appropriate for the scale and complexity of the asset classes
assumptions are sufficiently challenged and tested
Outputs inform: management actions and gross and net
impacts Pre-emptive responses to manage
vulnerabilities Strategy and capital/liquidity requirements
Firm strategy
OPERATING FRAMEWORK
Capital planning•Identifying capital required to support growth
• Link to ICAAP
Stress Testing
QuantitativeElements
(e.g. GDP, CPI)
Define scenarios
Identify consequence Assess impact (quantitative &
qualitative)
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GOOD PRACTICES – OPERATING FRAMEWORK
TYPES OF STRESS TESTS
TYPES OF STRESS TESTS
Exposure
Rating class
Sensitivity analysis
Defined by shift in sensitivity variable
Relatively easy to define and implement – often used at trading desk and business line level
Shifts in several variables have to be used in order to simulate historical events
Correct use of stressed correlations between risk types is essential
SENSITIVITY AND SCENARIO ANALYSIS APPLIED TO CREDIT RISK AND MARKET RISK
Sensitivity analysis Scenario analysis
Credit risk
Market risk(incl ALM)
What if all ratings worsen by one grade?What if default rates double in portfolios X,Y,Z?What if all correlations on our credit portfolio model increase by 20%?What is our collateral recovery rates are systematically 25% lower for real estate collateral?
What is the EUR/USD rate changes by X%?
Parallel shift of yield curve by X basis points?
Increased in implied volatility of European stocks of Y%
What if there was an emerging market crisis (contagion effects)?
GDP down 6-8%?
Deflationary vs. inflationary?
What if the previous historical boom and bubble in house prices leads to a long-lasting retail mortgage credit crisis?
What if exchanges rates or interest rates behave as they did historically during period X?
What if interbank liquidity dries up during next economic shock?
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THE CLASSIFICATION OF GLOBAL STRESS SCENARIOS
Global stress scenarios can be classified accordiing to the construction of the scenarios
Identification or relevant risk drivers and risk types. The corresponding elementary stress scenarios are then put together to yield a global scenario
Starting from a given multi-risk scenario, identified as being relevant to the risk profile, and the corresponding quantification in terms of single risk types
BOTTOM-UP
TOP-DOW
N
Moderate scenarios Challenging scenarios Extreme scenarios
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TOP DOWN APPROACH TO DEFINING STRESS SCENARIO
Senior management
Strategic planning department
Research department incl. chief economist
Competitive expectation
Macro-economic expectation
Risk controlling Moderation of scenario definition and portfolio input
Business & risk strategy
• What makes the business case profitable?
• What could endanger our business case?
• Where are the considerable concentrations (products, customers, markets) ?
• What are the biggest threats of our strategy?
• “What if” strategic decisions fail (e.g. acquisition, capital increase)
• On which economic drivers does the business case depend?
• What are macro-economic expectations?
• What about business cycle effects?
• What are unlikely by possible economic crisis?
• How would counterparties, customers and competitors be effected by a crisis?
Normal case planning scenario
Best case planning scenario
Stress case planning scenario 1
Stress case planning scenario 2
Stress case planning scenario 3
Translation of strategy into targets as well as business, risk and capital planning requires planning assumptions
Definition of planning assumptions
HIERARCHY OF STRESS TESTS
Global scenarios
Scenario analysis
Sensitivity analysis
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LINKING MACROECONOMIC EVENTS WITH THE TARGET METRIC
Process for thinking through linkage between macroeconomic events and target metric in scenario based layered stress-testing
GDP
Interest rates
Exchange rate
Debt ratio
Asset prices
Consumer sentiment
…
Macroeconomicfactors
Score distribution
Segment distribution
…
Portfolio characteristics
PD
LGD
EAD
Utilization
Attrition
Response
Delinquency
Process costs
…
Risk drivers
Portfolio loss (Accounting)
Portfolio loss (Economic loss)
Provisioning/Write-offs
Cap. Requirements
Reduced margins
Breakdown of new business
Fall in share price
…
Target metric
Historical:
Earthquake
Recessions
Credit crises
Hypothetical:
Extended recession
Correlation of events
. . .
Macroeconomicscenarios
REVERSE STRESS TESTING – TEST TO DESTRUCTION
Reverse stress testingReverse stress testing should be modelled through various stresses and consider factors relating specifically to the firm as well as the external environment.
Considerations when devising tests: Proportionality Basis of scenarios: hypothetical v
historical Internal v external shocks Idiosyncratic v market wide stress Rapid crystallisation versus protracted
impact Solo v Group
It should be used as a risk management tool – not a means of directly increasing capital requirements
Scenarios that could lead to
business failure
Mitigating actions or triggers for future action
Why do it?
■ Explore business model vulnerabilities
■ Engage senior management
■ Confront possibility of failure
■ Make decisions that better integrate risk management
■ Improve contingency planning
■ Inform stress testing framework
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EMBEDDING THE STRESS TESTING PROCESS
Suggests credit risk relevant scenarios covering bank wide, regional, portfolio or product specific credit risks
Suggests scenarios in ALM, market and liquidity risk
Suggests scenarios on external, fraud, litigation, IT or compliance risks
Suggest strategic, bank-wide and business case specific scenarios
Credit Risk Department
Market Risk Department
Operational Risk Department
Management / Business
First Pass Quantification
Workshop o better understand scenarios and underlying risks
Risk acts as moderator and supplies basic portfolio parameters in order to allow quantification
Discussion based quantification to extract insights before more rigorous first pass quantification by central team
Review of first pass
quantification Central project team
All scenarios are assigned a rough probability and impact
Prioritisation –Pilot Scenarios
Select based on probability and impact
Pilot scenarios based also on variety
Additional second tier risks to be covered later or at less accuracy
Review of selection
Reviews selection of pilot scenarios with representatives from (Sen.) Management, Business, Risk
Final Scenario Quantification
For each scenario estimates for probability and impact are justified by using various sources
Macro model (recessions, avian flu, real estate), benchmarks (most), theoretical model / distribution analytics (ALM, market, credit concentrations), external data (mis-selling), think tank (ship sunk)
Review of Quantification
Risk functions review results and provide comments, in particular for their own risks
Group risk is ultimately responsible for scenario analysis
Results reported to Management and Business
Senior Management bears ultimate responsibility
Scenario Generation Prioritisation Quantification
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STRESS TESTING DESIGN INVOLVES A LOT OF REFLECTIONS
• Under which scenarios is my business model seriously endangered?• What will cause my business model to fail?• What happens to my business in the next crisis?• Which risk drivers are relevant to my business?• In which scenarios would my largest sensitivities lead to major losses?• Whom in my organisation should I involve in the design, modelling,
parameterisation and evaluation of stress scenarios• How do I translate (top-down) scenarios to relevant risk drivers, and what
severity do apply?• What level of sophistication in describing and modelling of scenarios do I need
to apply to capture their essence?• Which parameters should be shocked (how)? Over what time horizon?• How are second order effects and feedback incorporated?• What do I do with the results of stress testing?• To what degree may I anticipate help from the outside (investors, central bank,
government)?
Design and strategy
Methodology
Implementationand evaluation
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KEY SUCCESS FACTORS WHEN SETTING-UP A STRESS TESTING FRAMEWORK
Adequately involve business and senior management at all
levels of stress testing
Clearly define the perimeter, i.e. the
group on a consolidated level
Identify the variables that have the most
effect on target variables
Clearly identify the target metric, e.g. the P&L, capital, external
rating,…
Validate stress testing results, question and
refine scenarios across time
Create a real risk culture across the organization – get
stress testing out of the risk function
Link stress testing results to action,
e.g. outright acceptance,
evaluate contingency
planning
THE IMPORTANCE OF STRESS TESTING LIQUIDITY
30 July 2007 17 August 2007 17 February 2008 14 March 2008 17 August 2007
15 September 2008 15 September 2008 16 September 2008
13 October 2008 National bail-outs: Germany - €470bn, France - €340bn, USA - $250bn bank nationalization, Spain - €100bn
15-31 October 2008 Tapped national bail-out fundsRBOS, HBOS, Lloyds, Commerzbank, Bank of America, JPMorgan Chase, Citigroup, Wells Fargo, Goldman Sachs, Morgan Stanley and more
“Many banks despite adequate capital levels experienced difficulties because they not manage their liquidity in a prudent manner……The rapid reversal in market conditions illustrated how quickly liquidity can evaporate and that illiquidity can last for an extended period of time…..” Basel 3
LIQUIDITY RISK STRESS TESTING
10 riskdrivers
Wholesale funding
Retail funding
Funding concentration
Franchise viability
I Intra-group liquidity
Marketable assets
Off-balance sheet
Intra-day liquidity
Short term market
disruption
Long term erosion in
funding sources due to
ongoing market
tightening
Name specific concerns
- restricting recovery
Combined stress test
Name-specific rumours and bad news.
Downgrade and negative outlook.
Retail run?
Wholesale run?
Institution specific
(idiosyncratic)
Market wide
(systemic)
Non-marketable assets
Basel 3 prescribes stress testing should consider the two types of stress tests below and combinations of both
Cross currency
First two weeks
Inability to roll over wholesale secured and unsecured funding
Sizeable retail outflow
Reduced intra-day credit provided by firm’s settlement bank
Increase in payments withheld to a clearer
Prefunding for all payments
Closure of FX markets
Intra-group deposits repaid at maturity, intra- group loans treated as evergreen
Multiple downgrade of long-term rating
Idiosyncratic Impact
Out to 3 months
Sustained leakage of funds
Sustained outflow
Gradual return to normality
Systemic Impact
Uncertainty of accuracy of valuation of assets and those of counterparties.
Inability to realise or realise particular classes of assets only at excessive cost.
Risk aversion in funding markets. Uncertainty as to the ability of a significant number
of banks to meet liabilities
LIQUIDITY RISK STRESS TESTING
Core Tier 1 as % of RWAs (base)
Core Tier 1 as % of RWAs (Stressed)
2011 2012 2013 2014 2015
£ m
ns
EXAMPLE OF A CAPITAL STRESS TESTING
Economic variable Year Base Case Regulatory mandatory test
Eurozone Sovereign
US GDP 2013 2.4% -1.8% -2.1%
Unemployment 2014 7.2% 13.4% 13.5%
House Price Index 2015 4.5% -13.1% -14.7%
Euro GDP 2013 2.2% -1.6% -3.9%
Unemployment 2014 7.1% 13.1% 15.2%
House price indices 2015 -2% -18.2% 19.1%
Illustrative numbers