Support strategic decisions with a sustainable approach to stress testing

Written By:

Dr Marie-Paule Laurent

Olivier Salomé

Tamar Joulia

Frédéric Van Weyenbergh

Scenario and stress testing for proactive risk management

2 | Scenario and stress testing for proactive risk management

Written by

Dr Marie-Paule Laurent

Managing Partner

mplaurent@riskdynamics.eu

+32 495 268 771

Olivier Salomé

Manager

osalome@riskdynamics.eu

+32 487 326 184

Tamar Joulia

Senior Expert

tjoulia@riskdynamics.eu

+32 495 590 101

Frédéric Van Weyenbergh

Associate Partner

fvanweyenbergh@riskdynamics.eu

+32 473 995 147

Risk Dynamics

Belgium: +32 2 340 00 90

London: +44 7970 462213

Netherlands: +31 20 2402750

Info@riskdynamics.eu

Scenario and stress testing for proactive risk management | 3

Introduction

Prior to the financial crisis that started in 2007, most financial institutions did not perform stress tests

from a comprehensive firm-wide perspective across all risk types and businesses. Instead, they

mainly relied only on individual risk models, assuming that historical trends constituted a good basis

for assessing the development of future risks. The crisis has revealed serious flaws in relying solely

on such an approach.

These models did not capture the possibility of severe shocks or how the combination of these

vulnerabilities behaves at a market level, amongst others due to their lack of interaction, which in

extreme conditions can drastically change the behaviour of fundamental economic risk factors. The

effects of this flaw were dramatically amplified as historical correlations proved to be unreliable.

Exposed by the market volatility, it became clear that most financial institutions had not paid sufficient

attention to these limitations of traditional risk models.

As market turbulences continue to affect financial institutions, stress testing has grown significantly in

scope and importance. Senior management have established comprehensive firm-wide risk

assessment processes in which stress and scenario testing play a material part, allowing better

informed and more timely decision-making. In particular, stress testing is considered as a key tool to

inform senior management about alignment of the institution’s risk profile with the Board’s risk

appetite, under various circumstances.

This white paper focuses on the use of stress testing for proactive risk management beyond

regulatory requirements.

This paper is divided into five sections:

Section 1 – Types of Stress Testing: We outline the context for different types of stress tests, including sensitivity analysis and scenario testing.

Section 2 – Context for Stress Testing: We introduce context in which these tests may be used.

Section 3 – Stress Test Process: We introduce an approach to conducting Stress Tests that brings together these tests and provides a sustainable approach that enables organisations meet their objectives

Section 4 - Creating value with Stress Testing: We demonstrate how the stress testing framework can be integrated in to strategic business decisions

Section 5 – In conclusion: Lessons learned and conclusions from Risk Dynamics’ experience.

4 | Scenario and stress testing for proactive risk management

Types of stress test

The following types of stress tests can be distinguished:

Sensitivity analysis provides a narrow view of individual changes.

A single factor analysis consists in assessing the sensitivity to one economic driver (e.g. the

interest rate) or one risk parameter (e.g. the counterparty default probability), using different

degrees of severity and without any economic story in mind. It can be supplemented by simple

multi-factor sensitivity analyses where a combined occurrence is assumed.

Both analyses provide information about risk concentrations in one or several risk factors, which

can help prioritise improvements in model accuracy.

This approach is limited, as the likelihood of change in the parameter(s) are not considered in

sensitivity analysis, nor the potential interconnection between the various parameters.

Given that changes rarely take place in isolation, this approach should only be seen as a stepping

stone to, or as part of, more sophisticated approaches.

Scenario and stress testing understand not only the impact but also the likelihood of multiple,

interrelated changes

Scenario testing typically relates to adverse events that have a ‘reasonable’ probability of

occurrence while stress testing refers to ‘exceptional’ events, to which a very low likelihood of

occurrence is assigned.

Both aim at assessing the impacts of these possible events on the financial and business positions

of the institution. System-wide interactions and second-order feedback effects are incorporated

within scenario and stress testing.

While this approach provides a robust view of the risks, it is not able to understand the possible

combinations of events and risk concentrations that would threaten the viability of the institution’s

business model.

Reverse stress testing consists in identifying a range of adverse circumstances which would

jointly cause the business plan of an institution to become unviable and in assessing the likelihood

that such events could crystallise.

Reverse stress testing also focuses on the institution’s specific vulnerabilities (e.g. reputational

event). Reverse stress testing is commonly used to identify possible combinations of events that

might not be considered in regular stress testing. It also helps to assess how close to failure is the

institution in its current environment.

A combined approach is required to ensure that the organisation understands its risk profile in a

variety of circumstances, due to the limitations of each type of test on a standalone basis,

Scenario and stress testing for proactive risk management | 5

A stress test for every occasion

Regulatory (or supervisory) authorities and internal management perform stress tests for

different purposes, on a regular or an ad hoc basis:

• Regulatory (or supervisory) authorities aim at controlling the resilience of each institution and the

financial system as a whole. Therefore, they prescribe severe scenarios, with a very low likelihood,

that institutions have to calculate. On that basis, they will decide on actions to enhance the

financial stability in the whole system (e.g. recapitalisation).

Financial institutions are required by the regulatory and / or supervisory authorities (FSA or EBA

and soon ECB) to perform stress tests at least once a year according to the capital rules.

The impacts of the scenarios are calculated per risk type, per portfolios and consolidated at

Group level. These are assessed over a period of at least two years, in order to take into account

the effects of some shocks.

Such exercises enable the authorities to evaluate the resilience of the institution’s risk profile to

‘stressed’ situations, and to compare the consistency of the results for similar portfolios and/or

institutions.

However, these scenarios and the selected metrics (e.g. solvency capital ratio, balance sheet,

market losses) do not address some specific vulnerabilities of the institution nor other material

risks (e.g. liquidity).

• Senior management aims to take actions that will optimise return on risks within shareholder’s risk

appetite. Therefore, it is interested in sensitivity analyses and more reasonable scenarios,

whatever their severity. On that basis, senior management will take actions to maintain or enhance

the institution’s value in a going concern basis within the agreed risk appetite.

Internal uses of stress testing include, among others, to capital & budget planning and

management of portfolio sensitivities.

The scenarios usually cover shocks related to the economic environment, the specific activities of

the institution and its operation and image (e.g. fraud, reputation).

It is up to the institution to select the most appropriate metrics against which the scenario and

stress testing outcomes are assessed.

6 | Scenario and stress testing for proactive risk management

Stress Test Process

The Stress Test is triggered by a request (imposed by the regulator or decided by the

institution’s management), with the purpose of obtaining an impact assessment and deriving

actions, which are then implemented.

FIGURE 1: The Stress Test Process

• Stage 1 - Origination: The key elements of the scenarios and stress tests are defined, e.g. the

type and objectives of the stress tests, their scope and perimeter, the characteristics of the

scenarios (likelihood, duration), the time horizon of the impacts, the level of granularity, and the

measures or metrics that will summarize the results (in absolute and relative terms).

• Stage 2 – Scenarios: Consists of first identifying all the scenarios that are relevant for the

institution. The set of scenarios that will be actually used is then selected from the institution own

repository of scenarios. The latter includes a narrative description of the scenarios, their likelihood,

and the type of shocks to which they relate (systemic, idiosyncratic, etc.).

• Stage 3 – Impacts: Running the tests demonstrates the impact of the scenarios on the selected

metrics. This three step activity begins with the translation of the stressed risk factors into internal

stressed risk parameters. The latter are then applied to the portfolios and risk types so that the

impacts can be measured. Finally, the results are aggregated at Group and entity levels.

• Stage 4 - Actions: The outcomes of the exercise are analysed, including the extent to which the

risk profile under stressed circumstances is aligned with the chosen risk appetite. The impacts of

• The stressed risk factors are

first translated into stressed

risk parameters. The latter

are then applied to the

portfolios and risk types

(with and without additional

risk mitigations). Impacts

are measured as deviatons

from the baseline. Results

are finally aggregated.

Act

ivit

ies

Origination Scenarios Impacts Reporting

Specify:

• Type and objectives of tests

• Scope and perimeter

• Characteristics of the

scenarios: likelihood/duration

• Reference date

• Time horizon of the impacts

• Level of granularity

• Measures / metrics

• Stakeholders

• Planning and milestones

• Approval and reporting

Actions

Analyse the outcomes

• Alignment of the risk profile

with chosen risk appetite

Test the impacts of actions

• Based on the tool(s) used

for the impact measure or

expert assessment

• Optional

Propose actions

Identify

• The scenarios that are

relevant in light of the

origination, the external

environment and the

institution’s business model

Select :

• The scenarios from the

repository

• The baseline

Or launch a request for:

• Additional scenario

Collect data

• In line with the

specifications defined in the

origination

Select models and

methodologies

• E.g. internal model

• Statistical methodologies

and expert-based

techniques

Apply the models and the

methodologies to the data

1 2 3 4 5

Communicate

• Internal management (e.g.

Group Board, ALCO, FRC,

Divisions Board)

Disclose

• Local regulator or other

bodies (EIOPA, etc.)

• Market participants

Embed

• ORSA report

Narrative description

Categories

• Systemic or idioscyncratic

• Historical or hypothetical

• Real of financial

• Rapid chrystallisation or

protracted effect

Assessment

• Likelihood and severity

• Stressed risk factors

• Contagion effects

To

ols

Repository

• Fit for purpose database

Data

Models

Methodologies

Origination Sheet Reporting Template

Scenarios Life Cycle

Management Actions

Risk Appetite

Categories

• Actions directly under firm

control

• Actions that require a

counterparty

Timeliness

• Immediately

• Early warnings

• Materialization of risks

Trigger Stress Tests Process

Imp

lem

enta

tio

n

© Risk Dynamics

Scenario and stress testing for proactive risk management | 7

actions can then be tested based on the tools used to assess the impacts of the scenarios or by

means of expert judgments. If needed, risk mitigating actions can be proposed to the senior

management.

• Stage 5 – Reporting: This phase aims at communicating the results to the internal senior

management of the institution (the Board or the relevant body depending on the type and purpose

of the stress tests). It might also be required to disclose the results to the local regulator or other

regulatory bodies (EIOPA) and market participants and to embed them in the ORSA report.

8 | Scenario and stress testing for proactive risk management

Creating value with Stress Testing

An enterprise-wide approach to risk management starts to break down the traditional silo approach

per risk type.

It enables organisations to identify the potential connections or correlations across multiple business

lines or units and across risk categories.

Proactive management leads to the identification of early risk mitigation and combined contingency

plans aiming at improving the risk, capital and / or liquidity positions of the institution.

Linking Stress Testing to Risk Appetite

The stress testing process is a key element of the qualification and quantification of the institution’s

risk profile, at corporate level and for key portfolios.

FIGURE 2: Usage Of Stress Testing In Risk Profile/Risk Capacity Assessment

Benchmarked against risk appetite, the assessment of significant losses (such as in earnings or in

value) associated with adverse events is used to identify where the institution should establish

contingency, continuity plans or take mitigating action.

This assumes an appropriate definition of risk appetite, reflecting the accepted variations in Earnings,

Capital and Liquidity positions as well as the types of risks an institution is willing to be exposed to.

Using Stress Testing to drive performance

Once established, the stressed positions of the institution’s portfolios can be benchmarked against its

tolerance for risk, and specific actions taken when the risk profile evolves toward a green, orange or

red zone:

Non Financial Resources

Risk Capacity

Global Control Framework

(Quality level assessed through

review, validation & audit)

Financial Resources Quantitative View

Risk Profile

Risk Assessment

Qualitative View

Stress &

Scenario

Testing

Action Plans

>

Risk

CapacityRisk Profile

Capital Capacity

(actual / target)

Earnings Capacity

(actual / target)

Liquidity Capacity

(actual / target)

Risk exposure

(actual / target)

Risk exposure

(actual / target)

Risk exposure

(actual / target)

Capital

Earnings

Liquidity

© Risk Dynamics

Scenario and stress testing for proactive risk management | 9

FIGURE 3: Performance Levels

For each Key Risk Indicator (KRI), the institution determines two levels of performance:

• The ‘target’ or ‘strategic’ level, reflecting the business strategy;

• The minimum level of performance (or maximum level of risk) is based on the institution’s

tolerance for changes in particular risk / performance indicators.

In the green area, the institution should consider reallocating excess resources to other business

initiatives.

Even in adverse scenarios, the indicators should not drop below the maximum level of acceptable

risk, but remain in the orange area.

Delivering Value

Calculated over an adequate time horizon, to reflect the cumulative and remote effect, scenario and

stress testing provide a range of forward-looking views on institution’s risks, and thereby contribute to

a risk sensitive capital and budget planning

The budgeting exercise is based upon a range of scenarios, covering the appropriate time horizon

(typically 3 years) and material firm-wide risk sensitivities.

In practice, the institution investigates the variations between the baseline and the adverse (but

plausible) scenarios to help controlling adherence to the chosen risk appetite.

This contributes to:

• A more efficient allocation of financial resources during the budgeting process.

The allocation can be conducted along two complementary dimensions:

‒ Per business, in line with the institution’s strategic priorities and relative value creation per

business line;

‒ Per risk category (credit, market, liquidity, underwriting, operational risks...) in line with the

institution’s tolerance in terms of losses and capital / liquidity requirements.

• A proactive management of risk appetite, by integrating risk and finance planning into the same

yearly process, so that the budgets are aligned with the institution’s risk.

• A proactive management of portfolio sensitivities across and within risk types.

GREENZONE

ORANGE ZONE

RED ZONE

Recommended Action:

Possible re-allocation of excess financial

resources

Closer monitoring, early mitigation, Capital contingency plan

Execution of the risk mitigation

plan

Target

level

Minimum

levelTolerance for risk

10 | Scenario and stress testing for proactive risk management

In Conclusion

Tell what the story tells...

In many instances, the characteristics of the scenarios (e.g. story, likelihood, severity, duration of the

shocks, horizon of the impacts) and the internal metrics used for the assessment are not precisely

described, if at all.

Be involved, at all level of the institution...

All too often these exercises are considered as a constraint imposed by the regulator, and are not yet

embedded in strategic and business processes.

Once fully integrated in day-to-day management, stress testing becomes a more powerful tool

supporting Senior Management.

Integrated teams, integrated approach...

Scenario and stress testing requires close cooperation between the various business, finance and

risk units.

Yet, a silo approach is still observed in some institutions, with the unintended consequence that the

overall risks and contagion effects can be underestimated. Integrated stress testing, covering all risk

types across portfolios and entities, can overcome this limitation by focusing on the

interdependencies for effective risk diversification.

Using the right tool for the job...

In assessing the impacts of scenarios, institutions too often rely on ad hoc adjustments directly

applied on the risk parameters. Methodologies do exist however, be it simple translation engines

(such as ‘satellite’ models) or more sophisticated econometric methods combined with expert

judgments (such as Bayesian Vector Auto Regression).

A combined approach is more than the sum of its parts…

All types of stress tests are complementary exercises. It is precisely for that reason that market best

practice recommends using sensitivity analyses, scenarios combined with stress and reverse stress

tests to provide a forward looking view that compliments historical risk analysis.

Stress testing, as part of an integrated approach to risk management can add value and

speed to business decisions, as it provides strong evidence about the performance of the

business under different conditions.

Scenario and stress testing for proactive risk management | 11

About Risk Dynamics

Risk Dynamics provides assessment services and strategic advice to banks, insurance companies, investment and asset management firms and

market infrastructures. We assess and benchmark risk / compliance management frameworks and risk models. We help financial institutions

optimize their frameworks and risk models for a more efficient use of financial and operational resources.

• More than 700 groups of models validated in different types of risks and domains

• A centralized and international team of risk management and compliance experts acting on a global scale

• Unique frameworks in line with the latest regulatory requirements, rigorously enriched with market best practices and benchmarks

• Regular contacts with regulators around the world

For more information please visit http://www.riskdynamics.eu

Disclaimer

This publication contains general information, and none of Risk Dynamics is, by means of this publication, rendering compliance, business,

financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or

services, nor should it be used as a basis for any decision or action that may affect your finances or your business. Before making any decision

nor taking any action that may affect your finances or your business, you should consult a qualified professional adviser.

No entity within Risk Dynamics shall be responsible for any loss whatsoever sustained by any person who relies on this publication.

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