Stress testing and scenario analysis in risk management

By David Brawn and Alan Cathcart Risk Review Department Financial Services Authority Presentation to PRMIA Seminar 25 October 2006

Outline of talk
A. B. C. D. E. F. Introduction Stress testing and risk management Stress testing and regulation Stress testing under Pillar 2 Thematic Review Conclusions

A. Introduction
• • • • Industry perspective Regulatory perspective Role of senior management What do we mean by stress testing and scenario analysis?

What is stress testing?
• Two varieties
– Sensitivity analysis (or single-factor tests) - identifying how portfolios respond to shifts in relevant economic variables or risk parameters; – Scenarios - assessing the resilience of financial institutions and the financial system to severe but plausible scenarios

B.

Stress testing and risk management
– – – – – – – – – Day to day risk management Business planning Capital planning Strategy-setting Firm- or group-wide scenarios Range of more static stress tests Business unit stress testing Market risk or credit risk stress tests Ad hoc stress tests

• What is covered by “risk management”?

• Programme of stress testing

How does stress testing help?
• Complements other risk management techniques – “Sanity check” – Reduced reliance on model parameters e.g. historical correlations – Can flex assumptions about business environment e.g. market liquidity, ability to raise capital, competitive position • Broad perspective – Portfolio or business wide perspective – Multiple horizons - sometimes instantaneous, sometimes years ahead • Transparency – Management action visible – Intuitive, easy to understand

Stress testing more than just a tool
• Stress testing assists senior management:
– Assessing their view of risks – Identifying risk concentrations – Focussing on severe but plausible events – Taking or planning mitigating action

C. Stress testing and regulation
• Regulatory attitude to stress testing
– Strongly in favour – Emphasis on role of stress testing in management of business – Stress testing being written into regulatory rules

• But
– Very little prescription from regulators

Why should this be?
• Financial regulation is forward-looking
– Focuses on adequacy of financial resources: capital, liquidity, etc. – Events which threaten objectives of consumer protection and market confidence

• Inability of regulators to monitor firms’ exposures in detail • Reliance on senior management of firms • Stress testing needs to be proportionate and adapted to the firm in question

FSA stress testing requirements
• FSA’s stress testing requirements derive from our Principles for Businesses Principle 3
“a firm must take reasonable care to organise and control its affairs responsibly and effectively, with adequate risk management systems”

Principle 4
“a firm must maintain adequate financial resources”

• Stress testing requirements also come from Basel, the CAD and the CRD

FSA stress testing requirements
• Market risk (Basel market risk amendment and CAD) • Credit risk (Basel 2 and the CRD) • Pillar 2 and GENPRU • Liquidity

Pillar 1 Market Risk
• Why? • Qualitative or Quantitative? • Stress Test Design • Prescriptive or not?

Why a Pillar 1 requirement?
• Only for VaR based capital • Regulatory VaR
– Short Horizon/Liquid Markets – Extreme tail of distribution – Completeness – Regulatory “Tinkering”

Horizon/Liquidity Issues
• Implicit in parametric models • Historic Simulation “memory” • How exposed are you to changes? • Liquidity Adjusted VaR is complex

VaR is a measure of risk in the tail
• In large portfolios correlation is dominant • Have we correctly parameterised? • Do we have sufficient data in His Sim?

Absent Risk Factors
• Insufficient Data • Computational tractability • Scenarios/Stresses used to generate capital requirement

Regulatory Tinkering
• Two adjustments from VaR to capital
– 60 day averaging – Multiplication by 3

• What is the final outcome?

Qualitative or Quantitative?
• Qualitative
– Supplementary management information – Challenge to VaR – Good measure of risk polarisation

• Quantitative
– Risks not captured in VaR

Stress Test Design
• The hardest question!
– “Severe but plausible” – Historical versus prospective scenario – Bottom up (“What’s the worst thing….”)

• Who’s responsibility?
– Senior Management involvement is critical.

Prescriptive or not?
• At this point the answer should be obvious! • Effective stress testing should be:
– Position Sensitive – Market Condition Sensitive – Business Development Sensitive

FSA and stress testing
• In 2005, two industry workshops, a Discussion Paper and a Feedback statement
– FSA Discussion Paper 05/2 “Stress Testing”, May 2005 – FSA Feedback Statement 05/02 “Stress Testing: Feedback on DP05/2”, December 2005

Comprehensive Approach
• In DP 05/2
– Six characteristics for an effective stress testing programme – Developed with the industry, not FSA guidance

• FS 05/2
– “we shall expect to see all firms, particularly the larger and more complex institutions move towards incorporating the principles of the Comprehensive Approach within their risk management systems”

Comprehensive approach (cont’d)
1. Senior management will be able to identify and articulate a firm's risk appetite and understand the implications of stress events within this context. Senior management will take an active part in identifying potential stress scenarios. Outputs from stress testing will be communicated to senior management in comprehensible format. 4. Senior management will have an overview of firm-wide risks and stresses and a concept of total risk even where precise aggregation is not possible. 5. Senior management will consider formally the implications of stress testing for a firm's strategy or business profile. 6. IT systems, resources and procedures will allow senior management to identify, quantify and manage efficiently the stresses that affect a group.

2.

3.

D. Stress testing under Pillar 2

Capital planning and stress testing Objective:
• That the firm can meet its capital requirements at all times through out a reasonably severe economic recession.

Why capital planning?
• Not only interested in adequacy of capital today • Want to be sure that firms will hold sufficient capital in the future

Two aspects:
• Capital planning; and • Stress testing.

Stress tests should be all encompassing
• Stress tests should be all encompassing and primarily cover: – Credit risk – Market risk – Operational risk • It will be also important for firm’s to consider second-order impacts: – Changes to portfolio concentration levels – Reputation (to the extent that the stress event is ‘name specific’) – Impact on availability of liquidity sources

Capital planning and stress testing
£

Base case (how do management expect the business to develop)
Capital

Capital generated as business grows

CRR

Additional capital needed as the business grows

time Yr 1 Yr 2 Yr 3 Yr 4 Yr 5

Capital planning and stress testing
£

In severe stressed case (pre management actions)

CRR •Firm makes losses

Capital deficit
Capital

time Yr 1 Yr 2 Yr 3 Yr 4 Yr 5

Capital planning and stress testing
£

In severe stressed case (post management actions)

•Cut dividends •Reduced costs

•Raised extra capital (eg share issue)

Capital (post)

CRR •Reduced business volumes Capital (pre) time Yr 1 Yr 2 Yr 3 Yr 4 Yr 5

Capital planning and stress testing
• Capital for future needs
• Projected CRR under stressed scenario • Plus;
– Losses; – Dividends – Other appropriations

• Minus
– Profits; – New capital raised (eg share issue) – Other management actions (eg cut costs)

Capital planning and stress testing
• Challenges
• Realistic base case • An appropriately severe stress test • Credible management actions

E. Thematic Review

Thematic Review in 2006
• Sample of ten large financial firms in the banking, building society and investment firm sectors. Visited firms in Q2 and Q3. • Objectives:
– Review of good practice – Assessment against the characteristics of the Comprehensive Approach

• Dear CEO letter sent to chief executives on 9th October, published on FSA website on 16th October. Link: http://www.fsa.gov.uk/pubs/ceo/stress_testing.pdf

Thematic review - results
• We saw a range of activity, with developments and improvements under way, but scope for further progress • Some issues
– Senior management engagement – Severity of stress events – Effectiveness of presentation and communication – Challenge or confirming business assumptions

Key findings
• Close engagement by senior management resulted in the most effective stress testing practices. • Good practice was observed where firms conducted firmwide stress tests of scenarios which were plausible, yet under which profitability was seriously challenged, key business planning assumptions were flexed or scope for mitigating action was constrained. • Communicating results clearly and accessibly was important for many firms • Good practice entailed using group-wide stress testing and scenario analysis to challenge business planning assumptions

F. Conclusions
• Stress testing valued by industry and regulators alike • Scope for progress within firms • Pillar 1 and Pillar 2 requirements are challenging • Dear CEO letter was published in October 2006 • Continued focus on stress testing by FSA • Stress testing can help reduce risk in the financial system

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