Stress Testing: A Practical Guide

In February, the Federal Reserve Board is expected to release scenarios for its 2020 Comprehensive Capital Analysis and Review (CCAR) and Dodd-Frank Act stress test (DFAST) exercises. Moreover, the European Banking Association recently published templates for its EU-wide stress tests. In short, despite the fact that DFAST requirements, in particular, have been scaled back, stress testing is still extremely important for both banks and supervisors.

Since the 2008-09 financial crisis, with the help of severely adverse scenarios and other stress tests, banks have significantly increased their capital buffers relative to risk-weighted assets. The financial system, moreover, now seems much better prepared to withstand a severe shock.

Banks have also used stress tests to improve their modeling, governance and data gathering, and there is now better communication between risk managers and business executives. All of this, of course, is linked not only to greater regulation but also to banks' understanding about the potential business benefits of the tests.

Stress testing is a forward-looking risk management tool for evaluating the potential impact of both unexpected events and changes in a firm's financial variables - including capital, asset quality and profitability. It incorporates risk into planning by providing the “what if” scenarios for the strategic and capital planning processes.

The establishment of risk appetite, balance sheet management, risk management and capital management are all inextricably linked to stress testing. The simple objective of stress testing is to keep institutions as a going concern balancing risk capacity (capital, earnings) with risk exposure (credit, market, operational, etc.).

Ultimately, stress testing should also lead to calls for action, which may take the form of, say, developing contingency plans, reducing concentrations, determining the appropriate dividend, or raising capital through equity or debt.

There is a three-item checklist developing effective stress testing: firms must (1) understand and deploy various kinds of stress tests; (2) build a comprehensive framework for modeling different scenarios; and (3) determine whether a top-down or bottom-up approach is the best strategy for evaluating the impact of shocks to macroeconomic variables.

Scenario Analysis, Reverse Stress Testing and Sensitivity Analysis

There are three types of stress testing:

Scenario Analysis entails the development of historical or hypothetical scenarios to assess the impact of various events. Scenarios usually involve a coherent, logical narrative that describes how events occur and in which combination and order.

Through scenario analysis, a firm can evaluate the impact of specified scenarios on its financial position. The scenarios can be chosen based on a defined probability of occurrence - for example, a 'one-in-a-hundred-years' event.

The application of scenario analysis shows the complex dependencies between several risk factors and their related key performance indicators (KPIs).

Reverse stress testing assumes a known adverse outcome and then deduces the types of events that could lead to such an outcome. This type of stress testing considers scenarios beyond normal business considerations, challenging common assumptions.

Sensitivity Analysis involves changing and stressing variables, parameters or inputs without an explicit, underlying reason or narrative.

Building a Proper Framework

Stress testing planning must be plausible, consistent, adaptive and reportable. This planning must be underpinned by a robust and effective framework that uses scalable reference data and relies on the efficiency and suitability of its forecasting models.

Furthermore, the framework should test the robustness of risk models: checking the sensitivity of models to different and divergent stresses may help evaluate their effectiveness. The adequacy and practicability of risk limits and triggers must also be measured, and relevant risk drivers should be identified.

Components of a Stress Testing Framework

Forecasting the impact of stresses and scenarios on the business plan can help prove, or disprove, the viability of that plan. Stress testing, moreover, should enable the understanding of the cause-effect relationship between stresses and changes in the risk profile of a company, allowing senior management to make prompt, well-informed business decisions.

Two Approaches

There are two common stress testing approaches: bottom-up and top-down.

The bottom-up approach evaluates the impact of shocks to macroeconomic variables at the most granular level of data. It considers shocks at individual customer levels, and the results are then aggregated to give a firmwide view of the impact on the firm's capital levels.

The top-down approach, in contrast, evaluates the impact of shocks to macroeconomic variables on a firm's balance sheet or income statement.

There are, of course, advantages and disadvantages (see chart, below) to each approach.

Stress Testing Approaches: Pros and Cons

Parting Thoughts

Stress testing can shape the risk profile of your organization. It identifies risk concentrations across various business lines, allowing management to form contingency plans while also providing for the integration of business strategy, risk management and capital planning.

What's more, it offers a forward-looking view of strategic opportunities, and promotes risk discussions that lead to enhanced internal and external risk communication.

John Thackeray is the founder and CEO of Risk Smart Inc. Over his long career, he has held many risk positions, including CRO posts where he interacted and engaged with US and European regulators. He frequently contributes articles on his risk insights to the Financial Executives Networking Group (FENG).