We are using cookies, in order to improve the site usage.
You can change your cookie settings at any time. Learn more
bg-arrow-down icon-arrow-up icon-back-to-top icon-linkedin icon-menu icon-search icon-twitter logo-white slider-arrow-left-gray slider-arrow-left slider-arrow-right-gray slider-arrow-right

Integrating Macroeconomic Scenarios in Stress Testing Workflow


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 follows:

  • 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.

For more information, contact BBA Marketing

+1 (905) 499-3618

Related Materials


Alternative Rating Development Approaches: Shadow Bond Approach

Where good-bad analysis cannot be used due to lack of default data, the ‘shadow-bond method’ offers a less robust but statistically valid alternative. Here the ability of financial factors to predict default is modelled by measuring their ability to predict external rating agency default rates.


Regulatory Approval of Internal Ratings Based Approach

More than ten years after the roll-out of Basel 2, many lending intuitions in Canada are still using the Standardized Approach (SA) for regulagtory reporting. As a consequence, reporting institutions are either setting aside disproportionately higher capital for their loan book, are engaged in regulatory arbitrage by issuing residential real estate loans or are involved in "originate-to-distribute" lending. All of these aofre-mentioned consequcnes contrinute to higher systemic risk.


Distribution Analysis for Information Risk (DAIR): A Cyber Quantification Framework

We know that cyber threats continue to evolve and pose increasingly significant risks to organizations. We also know that the impact of cyber-attacks extends beyond direct financial consequences. Cyber incidents can lead to serious service disruptions, reputational damage and share price deterioration, along with potential for fines and litigation. We also know that the impact of cyber-attacks extends beyond direct financial consequences. Cyber incidents can lead to serious service disruptions, reputational damage and share price deterioration, along with potential for fines and litigation.