This article describes how an advanced testing methodology can protect financial institutions from the risk of unknown shocks by integrating alternative macroeconomic scenarios into their stress testing workflow.
The convergence in capital management regulations and standardization in stress testing create a common analytical framework to consistently compare, assess and challenge capital position and resilience of financial institutions. Stress testing is essentially a ‘what if’ type exercise. Frequently, but not always, sensitivity stress testing contains symmetrical shocks up and down a given scale. Examples include, parallel yield curve shifts for interest rate risk analysis. A difference between scenario and sensitivity stress tests is that, most frequently, the latter address only one well-defined risk factor. In sensitivity stress testing, the source of shock is usually not identified. In stress testing based on macroeconomic scenarios, the source of shock event is well-defined. As the shock event sets in motion multiple risk drivers that change simultaneously with varying severity, the ripple effects are also considered.
One of the best ways for performing scenario analysis is the Delphi method. It permits a systematic and direct use of expert judgement, taken from a statistically significant sample. Successive iterations are stepping stones towards the definition of a likely outcome, or the selection of the most crucial factors among several top-level variables.
Regulatory authorities now demand comprehensive stress testing, covering both, sensitivity and scenario-based stress testing. For example, the OSFI requires the application of both scenario and sensitivity stress testing (See: Stress Testing: Sound Business and Financial Practices). The Federal Reserve’s Dodd-Frank Act Stress Testing focuses pre-dominantly on scenario-based stress testing. In contrast with the other regulators, the Federal Reserve prescribes stress scenarios and macroeconomic risk drivers. Similarly, European Banking Authority (EBA) conducts EU-wide stress testing using scenarios which cover a projected period of 3 years.
Unlike the OSFI, the EBA and Federal Reserve are more prescriptive in their instructions by laying out a common methodology, internally consistent and relevant scenarios, and a set of templates that capture starting point data and stress test results to allow a rigorous assessment of the banks in the system.
By developing forward-looking scenarios, financial institutions can identify risk hotspots, develop early warning signals, define the quantum of acceptable severity to help calibrate the risk appetite.
Defined relationships between macroeconomic variables and losses or default rates tend to break
during the times of crisis. For instance, a shock scenario attributed to COVID 19 can play out as
- Drop in employment
- Drop in GDP
- Drop in occupancy of multi-tenancy real estate
- Increase in loan losses
Under the historic regulatory toolkit which was based on a premise that “past is the good indicator of future”, the severity of the current-day shock events could not be modelled. In addition, traditional capital management models (e.g., Economic Capital models) are exposed to the procyclicality risk. Procyclicality is the extent to which the buffer between available capital and required capital levels (regulatory and economic) changes as a direct result of changes in the economic cycle.
Studies show that there is greater procyclicality in simulations calibrated to the transition behavior of point-in-time defaults than in simulations calibrated to agency rating histories, which is based on through-the-cycle. All things being equal, by using forward-looking scenarios, effective capital management programs can be designed to diminish the procyclicality risk.
Future strategic plans, and therefore financial projections, must take a view of emerging economic conditions. This involves a focus on ‘stay-in-business’ strategies for internal management while managing external disruptive scenarios on many fronts. By postulating scenarios, and assessing their bottom-up impact on P&L, NII, liquidity and capital institutions can assess their resilience to adverse market developments.
The integration of scenarios into stress testing frameworks remains an open challenge for most financial institutions. Existing processes rely heavily on manual spreadsheet work that carries inefficiencies and computational challenges.
Delivered in an easy-to-use web-based front end, BankingBook Analytics’ (BBA) ScenarioFrontier provides users the flexibility to create customized scenarios, the power to analyze strategic plans, and the oversight to monitor budget performance.
BBA’s ScenarioFrontier software delivers integrated finance, risk, and treasury platform to optimize capital management and risk-adjusted profitability using wide-ranging macroeconomic and microeconomic scenarios. Our product is tailor-made for clients of any size and can easily be scaled up or down to meet the specific needs of senior managers including CFOs and CROs.
Author - Sohail Saad
To learn more about BBA’s ScenarioFrontier, please visit us here.