A short review of stress testing regulatory frameworks.
Stress testing is evaluating the impact of large, expected as well as unexpected shocks on a bank’s capital. With the global financial crisis of 2008, EU debt crisis, Libor scandal and rampant rogue trading, it has become vital to judge a financial institution’s strength in coping with large shocks. Extreme events, it seems have moved out of the ‘once-in-a-lifetime’ black swan mode into daily lives.
In a crisis, emotions run high and rational boundaries break easily as survival instincts take over. That’s why regulators and bank managers understand that the right time to develop and manage a risk management strategy for a crisis is when there is no crisis; when the market is behaving normally. This allows the Board of Directors, specialists and market participants to think clearly.
In this note we review the regulatory requirements for stress testing as specified by:
- US Federal Reserve – representing North America
- The British FSA – representing non-EU Europe
- Monetary Authority Singapore (MAS) – representing the Far East
- State Bank of Pakistan (SBP) – representing MENA.
A quick comparison reveals:
- Level of regulatory involvement: This varies as Fed has a much more involved approach into stress testing bank than SBP. Involved here means Fed does not just asks banks to perform their stress testing, it goes on to do its own stress testing as well.
- The depth of analysis: Shocks and methods like scenario testing are used more by Fed than SBP
- Level of innovation: MAS follows an innovative process for evaluating operational risks stress tests which other regulators do not.
- Level of reliance on international resources: While all follow international procedures some are more independent than others like Fed is less reliant on international resources than MAS.
While these are the differences, there is a common theme. Results of the regulatory body will be held supreme in case the results of stress testing by regulator and individual bank differ.
Stress Testing: Sensitivity versus Scenarios
There are two approaches to Stress testing.
a) Sensitivity analysis, and
b) Scenario analysis.
Sensitivity analysis sees the impact of changing one factor on the portfolio or profile at a given time. It is simplistic in the sense that for testing purposes factors only change one by one. While in real life factors usually change together and not in isolation. It also does not tell us why the factor is changing or the probabilities associated with such an occurrence.
Scenario testing covers for these deficits. It includes variables that explain why the change is happening and to what extent. It allows for interaction between factors. By not holding all factors constant, correlations between different explanatory variables are taken into account.
Generally, across all regulatory frameworks and guidelines for stress testing, regulated banks are required to:
- Develop an effective stress testing program
- Incorporate stress testing in their regular risk assessment and reporting frameworks
- BOD has oversight and approval of risk management policy responsibility whereas senior management, in particular the head of risk management has implementation responsibility
- Stress testing should be part the governance and risk management culture of the bank. Results from tests should be incorporated in the banks strategies, business decisions and capital allocation processes.
Actions based on stress test results include:
- Reduction in risk limits if tolerance levels are breached
- Risk mitigation through collateral and hedging
- Re-pricing portfolios
- Additional arrangements for sufficient available funds
- Strengthening of capital base
Stress Testing: US Fed stress testing framework
In calculating stress test scenarios in 2012, Fed took data from 19 participating Bank Holding Companies (BHC) that had consolidated assets of $50 billion or more.
The stress testing is done under the supervisory assessment umbrella of Comprehensive Capital Analysis and Review (CCAR).
CCAR objective is to litmus test capital adequacy of important Bank Holding Companies (BHC). From the data, the Fed calculated capital, losses, expenses and revenues ratios under the stressed environment for each of the 19 Bank Holding Companies (BHC).
Apart from assessing the qualitative worth of the plans of Bank Holding Companies (BHC) for capital development, it was also seen whether Bank Holding Companies (BHC) can satisfy the various ratios such as ratio of tier 1 common capital to risk weighted assets of at least 5% under both normal and stressed situations.
Models were built and used by Fed for generating these projections based on conservative assumptions.
Stress Testing: The Supervisory Stress Scenario: Worst case scenario
The Supervisory Stress Scenario starts with a deep recession in USA, with significant decline in global economic activity and unemployment levels reaching those as in previously recorded recessions.
The recession begins in the last quarter of 2011 and continues throughout 2012 with unemployment levels attaining 13% by second quarter of 2013. During this time, US equity prices fall by as much as 50% and US House prices by 20%. Global slowdowns occur in Europe and Asia as well. The EU debt crisis is also given importance and economic conditions in Europe are expected to deteriorate.
25 variables were included with 13 pertaining to economic and financial factors. The stress scenario time horizon is fourth quarter 2011 to fourth quarter 2012, i. e, total of nine quarters.
The advantage Fed has is that it has access to the what-ifs of the banks under different limits. The Fed can use this to gauge stressed scenario and assess if remedial actions are enough or not. Various volatilities are taken into account as well.
Stress Testing: Results from the US Fed Stress test
The result was that 4 Bank Holding Companies out of 19 failed these tests and would fail if the stress scenarios occur and hence, pose a threat to the entire financial system. The failed entities were Citicorp, MetLife, Ally and SunTrust.
Stress Testing: FSA UK Stress Testing
The FSA in UK follows an integrated approach.
- Firms develop and implement their own stress tests
- FSA regularly runs stress tests on firms that carry high impact or as the need dictates
A common scenario is specified for all firms and they undertake stress testing based on that common scenario.
Figure 1 Stress Testing: The UK FSA Stress Testing Framework
The third aspect of a common scenario is still under development.
Stress Testing: FSA Reverse stress testing
After much consultation, reverse stress testing was introduced in the stress testing framework. Reverse stress testing uses a capital shortfall approach that focuses more on the size of the shock required to sink an entity.
There are different regulations for reverse stress testing to be on just the individual firm level, group level or both depending on the legal structure and size of the organization. Capital planning stress scenario under Pillar 2 which is supervisory review should also be taken into consideration.
Stress Testing: More insights from UK
FSA intends to introduce supervisory recommended scenarios, recognizing its advantage as a regulator. These may differ from the common stress scenarios. A comprehensive range of risks have to be identified and applied in determining the different shocks like market risk, operational risk, group risk, pension obligation risk etc. Correlation between the different risks is also to be taken into account.
FSA recommends that both sensitivity analysis and scenario analysis should be included in stress testing as appropriate and feasible. Macro indicators that affect the economy should also be taken into account into the scenarios, particularly to which stage of economic cycle is a firm most exposed in.
An important thing in this process is consistency; the scenarios should not be over-estimated in times stress and less severe during a boom in the economy. The plans on capital adequacy should also show what actions management of the firm intends to take if such a documented stress scenario occurs in reality.
Monetary Authority of Singapore (MAS) stress testing framework
MAS published its latest annual financial stability review on November 2011. This recorded and described in detail the macro economic factors in the economy and having the likely impact of these factors on the financial market.
Stress Testing in the Far East: Exercise Raffles III
In September 2011, an industry wide exercise was run for the financial sector as a drill to prepare it better if harmful operational risks occur. This exercise code-named Exercise Raffles III (ER III) brought operational risks to the forefront in stress testing for Singapore. Operational risk is the risk of failed internal systems, processes, and people or from external unknown events.
ER III had the theme of physical and cyber terrorism. Physical terrorism included hostage situations and swarm attacks like the one in Mumbai a few years ago and for cyber terrorism it included widespread hacking, viruses and disruptions of technology infrastructure.
The key objective of this exercise was for financial firms to assess and review in-depth their Business Continuity Plans (BCPs) left to counter these operational risks and whether they are sufficient or not in such a scenario.
137 financial institutions took part in this exercise. This was coordinated with government security agencies as well like the police force and Ministry of Home Affairs.
The exercise was conducted at desktop level for 3 hours for each participant. Simulations were run and a number of communication mediums were employed to test the behavior of the participants like emails, calls, news and short messaging services.
MAS Stress testing framework
MAS also require financial institutions like banks and insurance companies to undertake stress testing on a regular basis. Aside from this, MAS conducts periodic (mostly annual) stress tests of the financial sector on its own. The objective is to assess both the sustainability of the individual firm as well as any contagion effects it can carry on Singapore’s financial market.
The stress test undertaken by MAS most recently was in the first quarter of 2011. It showed that no financial firm would go bankrupt in the prescribed stress scenarios.
The process for the industry wide stress test is two-pronged. First, MAS with consultation with international financial and monetary bodies and local surveillance operations develops scenarios with shocks to key risk parameters like GDP, yield curve, credit spreads etc. This is than subject to review by international peer of regulators. Once the scenarios are finalized, they are channeled to financial institutions which are required to conduct stress tests according to the prescribed scenarios.
Stress testing guidelines from the MENA region: State Bank of Pakistan
The new guidelines on Stress Testing released by the SBP in May 2012 present:
- 16 pre-defined mandatory stress tests which are sensitivity analysis based
- Additional guidelines for non-mandatory stress tests for internal purposes based on scenario analysis and reverse stress testing as well as guidelines for operational risk stress tests and stress tests for Islamic Banking Institutions.
- Banks with at least 4% of the total banking market shares of assets will be required to submit results of these non-mandatory tests to SBP by 31st Dec 2012.
Stress Testing: Mandatory stress tests
The features common to all the mandatory stress tests include:
- Carried out on a quarterly basis
- On prescribed formats
- Submitted to SBP within 30 days of end of quarter
- For credit, market and liquidity risks
- Each test has 3 levels of shocks (minor, moderate, major; varies by intensity and magnitude)
Stress Testing: Credit Risk Scenarios
Credit risk is the risk of counterparty defaulting on its obligations. There are 6 shocks that are considered in stress testing for credit risk.
1. Adverse shock in the overall credit loan portfolio. What if the movements are so macro that it leads to all sectors; overall credit loan portfolios to deteriorate in quality? The first level of shock is:
- 5% of performing loans move to substandard,
- 50% of substandard loans move to doubtful and
Note that while the first percentage fall is 5%, this is followed by 50% fall in the other categories. This is how the economy practically behaves; in waves of defaults and grades of credit quality.
2. The default of top private borrowers. The default of top 2, 3 or 5 borrowers is to be assessed respectively. The point in making this process is to analyze the actual concentration risk of a bank; is a bank too reliant on few top borrowers for its running?
3. Shocks to various sub-sectors of overall credit loan portfolio are to be evaluated so as to check the extent of concentration of bank towards a few sectors.
4. A scenario for degradation of credit quality for borrowers that are below investment level.
5. A scenario for degradation of credit quality of corporate clients’ credit.
6. A shock in default rates for small and medium enterprises and agricultural loan portfolio.
The final credit risk scenario analyzes the impact of the deterioration of consumer loan portfolio.
Stress Testing: Market Risk Scenarios
- Market Risk is the risk of falling value of assets and financial prices or price risk for short.It is composed mainly of four factors:
- interest rates,
- exchange rates,
- equity or stock prices and
- commodity prices.
Therefore the first shock here is the impact of the decrease in interest rates on the earning assets by 2%, 3% or 5% on the net interest income. Followed by the impact of a parallel shift in the yield curve on an upward direction or the value of assets?
- What is the impact on market value of assets due to change in the slope of the yield curve (steepening or flattening)? The impact will be different for assets at different maturity buckets and has to be aggregated to reach a holistic value.
- Quantify the impact of an increase in rate on the market value of Available for Sale (AFS) and Held for Trading (HFT) instruments.
Stress Testing: Liquidity risk scenarios
Liquidity risk refers to the level of incapacity of a bank of having insufficient liquid assets to meet its contractual short term obligations. The first type of liquidity risk is funding liquidity risk which is the risk of the money market platform not providing funds to the company when required. The second is market liquidity risk which is the market’s inability to execute a transaction when required without a substance brunt on prices.
- Shock of significant withdrawal of deposits for Day 1, 2 and 3. This will enable the bank to analyze how dependent is it on the deposits and be able to judge the sufficiency of the liquid assets it holds.
- Shock of withdrawal of material amount by inter-bank borrowing and the whole sale private sector. These are providers of liquidity in bulk amounts and an important source of liquidity for any bank. So it is necessary to see that if for 3 days they become unreliable, what will happen to the bank.
- The impact of withdrawal of top depositors. This will test the bank’s liquidity concentration limit.
- The effect these shocks have on the Liquidity Coverage Ratio (LCR) where LCR is the number of times the short term assets are able to service or cover the short term liabilities.