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Regulatory Stress Testing -


A Comparative Study
Contents
1. Executive Summary ..................................................................................................................................................................... 3

2. What is Regulatory Stress Testing ............................................................................................................................................... 4

3. Evolution of Stress Testing .......................................................................................................................................................... 4

4. Comparison Among CCAR/DFAST, EBA, and PRA Stress Tests ................................................................................................... 5

5 Stress Testing Across the World .................................................................................................................................................. 7

5.1. DFAST/CCAR ...................................................................................................................................................................... 7

5.1.1. Evolution of Regulations ...................................................................................................................................... 7

5.1.2. Process ................................................................................................................................................................. 8

5.1.3. CCAR/DFAST Framework 2016 vs 2015 .......................................................................................................... 9

5.2. EBA .................................................................................................................................................................................... 12

5.2.1. Evolution of Regulations .................................................................................................................................... 12

5.2.2. Process ................................................................................................................................................................ 12

5.2.3. EU-wide Stress Test Framework 2016 vs 2014 ................................................................................................ 13

5.3. UK PRA .............................................................................................................................................................................. 15

5.3.1. Evolution of Regulations .................................................................................................................................... 15

5.3.2. Process ................................................................................................................................................................ 15

5.3.3. PRA Framework .................................................................................................................................................. 17

5.4. Conclusion ....................................................................................................................................................................... 19

Authors
Prateek Mukherji
prateek.mukherji@moodys.com

Raghav Seth
raghav.seth@moodys.com

Ramachandran Ramaswamy
ramachandran.ramaswamy@moodys.com

2 CCAR Results 2016


Executive Summary
In the wake of the 2009 financial crisis, regulatory bodies around the world realized the need to make financial institutions undergo
supervised rigorous tests to ascertain their robustness. Although financial institutions were subject to such conditional testing earlier, the
continued impact of the crisis on markets led regulatory bodies to devise advance methods and risk framework to plug gaps.

Stress testing of financial institutions involves simulation techniques to gauge the impact of certain shocks and stressed macroeconomic
variables on the performance and stability of the institutions and eventually the markets. It includes the use of computer-based
quantitative methodologies (models, techniques, etc.) to assess the financial capacity of these institutions under hypothetical and,
sometimes, highly customized scenarios. These scenarios hypothetical potential crisis events are developed by regulatory bodies and
are generally based on the current economic situation as the base case. Further, these scenarios are developed or created as shock events
with prolonged effects solely for the purpose of conducting the tests. Financial institutions also need to develop their own scenarios
specific to their firm under a scenario-expansion exercise. All institutions submit detailed reports to regulatory bodies for their review,
suggestions, and approval. Following their review, regulators release a consolidated report on the tests.

Stress testing also allows regulators to assess banks resilience to a range of macroeconomic shocks and ensures banks have sufficient
capital to withstand these shocks. In addition, these tests evaluate the capital planning, as well as risk assessment, and modeling
capabilities of banks. These hypothetical adverse scenarios are accompanied by a baseline scenario to evaluate the relative loss of a bank
under normal macroeconomic conditions.

Although the rules and acts are similar across the globe, various authorities worldwide have their own sets of rules and acts, which define
their requirements for effective risk management. In reality, they follow the requirements of the Basel Accords.

This paper dwells on the qualitative aspects of stress testing, including the need and requirements, origination and evolution over the
years, and the different stress-testing methods employed by major regulatory bodies: the European Banking Association (EBA), the
Federal Reserve (Fed), and the Prudential Regulatory Authority (PRA)
The differences and similarities among Stress Testing exercises across regulators
It also highlights new stress-testing principles adopted by regulators and key differences between the current and previous
stress-testing practices

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What is Regulatory Stress Testing
Stress testing involves scenario testing and a review of the capital adequacy ratios of financial institutions under hypothetical financial
crisis events, which help determine the steps that need to be taken to help these institutions withstand such crises. The capital adequacy
ratios provide an idea of the level of liquidity in each bank and ensure they do not end up insolvent. By preventing financial institutions
from going bust, stress testing ensures the stability of financial markets, especially global systemically important banks (G-SIBs), which are
considered too big to fail and whose collapse would impact economies around
the world.

This mandatory regulatory exercise is carried out by analyzing the models used by the institutions to predict their capital positions
(profits, cash flow positions, etc.). Quantitative methods (Monte Carlo, etc.) are used for the simulation of the models to arrive at capital
positions and compare with the regulatory-requirement levels. Unless the required levels are met, the regulatory body does not allow the
institutions to continue with their existing models and plans. The institutions are required to incorporate the suggestions and changes and
comply with the requirements to get certified by the regulatory body as having passed the stress test.

G-SIBs generally undergo multiple stress-testing exercises, most of which are mandatorily carried out by regulatory bodies, and a few
are performed by these banks themselves, the results of which need to be reported to their respective regulatory body. In both cases,
models pertaining to the predictions of balance sheet items, risk-weighted assets (RWAs), net income, etc. are simulated on the basis
of macroeconomic scenarios assumed over a planning horizon to arrive at post-stress-level values. This planning horizon and the
macroeconomic scenarios are determined as per the capital action plans of the regulatory body and the financial institution in question.

Evolution of Stress Testing


Stress testing is not a new concept. It has been in existence for a long time, but in various other forms and not as part of any mandatory
regulatory exercise. Banks and financial institutions have been using stress-testing techniques, such as the Black Scholes model and the
Monte Carlo method, since 1970s. These exercises, usually run by consultants for internal assessment and risk management only, were
completely unsupervised and based on an institutions perspective of
economic conditions.

As the markets became more vulnerable to risky business activities and suffered from shocks around the world, financial regulatory
authorities (especially central banks) and the governments of countries woke up to the importance of supervised risk management
exercises. Consequently, since mid-1990s, regulators have stepped up efforts, enacting various acts that created committees and bodies
and spelling out rules institutions had to comply with.

A part of Bank of International Settlements (BIS) based in Basel, the Basel Committee on Banking Supervision (BCBS) issues banking
supervision regulations. BCBS a committee of banking supervisory authorities was established to provide a forum for regular
cooperation in banking supervisory matters increase the understanding of key supervisory issues and enhance banking-supervision quality
worldwide. The committee frames standards and best practices guidelines and in capital adequacy, effective and cross-border banking
supervision, efficient market and operational risk management, etc.

BCBS was also formed to frame a set of broad supervisory guidelines and standards for voluntary implementation by the authorities of
member nations across their own national systems. These guidelines, seek to closely monitor financial risks faced by banks and financial
institutions and safeguard them from such risks by establishing supervisory controls on these risks. On the basis of the recommendations
and the guidelines, the various member nations form their own acts and committees, eventually frame stress-testing activities.

Key takeaways:
The major changes in the regulatory stress-testing framework were made after the 2009 financial crisis, as regulatory bodies around
the world realized the deficiencies in risk measurements of banks to cope with adverse economic scenarios and the ripple effect of the
crisis on other economies. Since then, all major economies have developed sophisticated methods for stress testing banks to ensure
that same crisis is not repeated.

4 CCAR Results 2016


Comparison Among CCAR/DFAST, EBA, and PRA Stress Tests

CCAR/DFAST EBA PRA


Inclusion BHCs with $50bn or more of A minimum total consolidated asset Seven banks and building
consolidated assets have to undergo size of EUR20bn was necessary for societies, which accounted for
supervisory stress test (DFAST/ inclusion in the 2016 stress test 80% of the outstanding stock
CCAR) The EU-wide stress test is of PRA-regulated banks, were
In the 2016 supervisory stress conducted on a sample that forms covered in the 2016 stress test
test, 33 BHCs participated in the 70% of banking sector assets in
regulatory stress test the eurozone, non-eurozone EU
member states, and Norway (51
banks in 2016)

Tests CCAR is a supervisory annual stress The EU-wide stress test is an annual Annual cyclical scenario is a
test to evaluate a banks capital supervisory test that provides a concurrent stress test conducted
adequacy, capital planning process, common analytical framework by the FPC and the PRA to
and planned capital distributions in to EU banks and the EU banking identify resilience of the banks
stressful economic scenarios system to evaluate the resilience of under hypothetical stressful
DFAST is a quantitative assessment the banks to macroeconomic and economic scenarios and ensure
of the effects of stressful economic microeconomic shocks, as well as the banks are sufficiently
and financial market conditions on a the capital position of the banks capitalized
BHCs capital under an adverse economic scenario The biennial exploratory scenario
Other than the annual supervisory stress test evaluates risks not
stress tests, conducted by the Fed, covered under the annual
all financial companies with total cyclical stress test. It explores
consolidated assets more than the emerging or latent threats
$10bn are required to conduct to the stability of the economy.
annual company-run stress tests Unlike the cyclical stress test, the
exploratory stress test may vary in
nature for each exercise

Scenarios Three common scenarios are The EBAs exercise evaluates the The ACS test a UK bank undergoes
baseline, adverse, and severely performance of the banks under is similar to those subjected
adverse scenarios common macroeconomic baseline to their US and European
The baseline scenario follows a and adverse scenarios counterparts, with tests around
profile similar to average projections The adverse scenario reflects baseline and severe scenarios and
of US real economic activity, four systemic risks that currently testing criteria involving capital
inflation, and interest rates represent the most material threats adequacy
The adverse scenario covers weak to EU banks: ratios andhurdle rates:
economic activities, deflationary Low liquidity in secondary market The adverse scenario projects
pressures, near-zero short-term Weak profitability prospects and vulnerabilities across financial
interest rates in the US, and tight financial conditions markets and the domestic
financial conditions for corporates Increased concerns over debt economy and a global
and households sustainability downturn in output growth. A
The severely adverse scenario Low nominal growth of economy sharp fall in asset prices, along
encompasses severe global Rising shadow banking sector, with volatility in the financial
recession, heightened corporate amplified by spillover and liquidity and property markets, is also
financial stress, a sharp drop in asset risk included
prices, and negative yields on short- It is less strict than CCAR The biennial exploratory scenario
term US Treasury securities explores emerging or latent
threats to the stability of the
economy
It is less strict than CCAR

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CCAR/DFAST EBA PRA
Scenario Various methods of scenario The ESRB designs common adverse The ACS framework ensures
design development allow flexibility scenarios on which stress tests are severity varies in line with risks in
in changing correlations and conducted, while the European the credit and financial markets.
dependencies among risk factors Commission provides the baseline When risks are higher, the severity
The scenario design framework is scenario of the scenario should increase
not limited to historical episodes. The scenario design framework and vice versa
It has a range of options and includes a common set of stressed Additional variables are calibrated
approaches, which can be modified market parameters and variables, using long periods of historical
by incorporating specific risks or calibrated from the macroeconomic data to capture a full credit cycle,
using a probabilistic approach scenario and historical experience rather than limiting to periods of
macroeconomic stability
Balance sheet A static balance sheet is assumed The EBA assumes a static balance Stress testing projections include
treatment A BHCs balance sheet is projected sheet, which implies balance sheet changes in the composition of the
according to a model that takes into items that mature within the balance sheet
account industrywide loan and non- horizon of the exercise need to Dynamic balance sheet is
loan asset growth be substituted by similar financial applicable to both baseline and
A BHC is assumed to maintain a instruments at the start of the severe stress scenarios
constant mix within the loan and exercise Asset quality review is undertaken
trading asset categories. Each A static balance sheet is applicable
category is assumed to grow at a to both baseline and severe stress
constant rate scenarios
Asset quality review is not done Asset quality review is carried out

Planning 3 years 3 years 5 years


horizon
Model Models are developed by regulators Credit, market, and operational risk Stress test projections are
use in supervisory stress tests losses are projected using a banks calculated using various models
A banks internal models, along internal models and analysis, including models
with regulatory models, are used in developed by both participating
company-run stress tests banks and regulators

Risk factors Supervisory risk assessment Risk assessment includes factors In the ACS test, risks include
includes: such as yield of bonds, foreign variables such as global activity,
Domestic factors such as exchange, asset prices, eurozone financial markets, UK property
economic activity, asset prices, activity, and company-specific prices, and UK economic activity
and interest rates shocks The biennial exploratory scenario
Global factors such as real covers emerging or latent threats
GDP growth, inflation, and to financial stability and may vary
the exchange rate of global from one exercise to another
economies
Company-run stress tests include
company-specific shocks and
supervisory risk factors

Hurdle rates Banks need to maintain Tier 1 capital There are no hurdle rates in the Banks need to maintain Tier 1
ratio above 4.5% in all the scenarios EBAs stress test, and results are capital ratio above 4.5% in all the
Tier 1 leverage ratio should be above used for SREP evaluation scenarios
4% Tier 1 leverage ratio should be
above 3%

Key takeaways:
Even though there are major differences in the methodology and principles in the US, the EBA, and the PRA stress tests, the rationale
behind conducting such tests is common across regulators: evaluation of the resilience of banks in an adverse economic situation. All
stress tests are forward-looking quantitative and qualitative assessments of banks.

6 CCAR Results 2016


Stress Testing Across the World

DFAST/CCAR

Dodd-Frank Act supervisory stress testing (DFAST), along with comprehensive capital analysis and review (CCAR), are forward-looking
supervisory stress tests conducted by the Fed to identify whether the largest banks in the US have sufficient capital to negate the impact
of stressful economic and financial market conditions. Banks with consolidated assets of $50bn or more are evaluated to ensure they have
robust forward-looking capital planning processes to mitigate their unique risks.

DFAST (complementary to CCAR) shows how bank holding company (BHC) capital ratios can change under a hypothetical set of
economic conditions and macroeconomic scenarios developed by the Fed. It serves as a raw material for quantitative assessment in CCAR
after a bank has incorporated its capital planning process and planned capital distributions. Other than carrying out supervisory tests,
BHCs in the US have to conduct annual company-run stress tests for the same supervisory scenarios, planning horizon, and capital actions
assumed in DFAST. They also have to perform a midcycle stress test under company
developed scenarios.

Shocks are calibrated under three macroeconomic scenarios (baseline, adverse, and severely adverse) to estimate a BHCs projected
losses, pre provision net revenue, and capital adequacy. Both DFAST and CCAR assume the same set of stress scenarios and
macroeconomic shocks to project net income, total assets and RWAs. The difference lies in capital action assumptions. DFAST employs
a standardized set of capital action assumptions to project post-stress capital ratios, whereas CCAR uses a BHCs planned capital actions
to determine a banks resilience in stressful scenarios. Results of DFAST and CCAR differ significantly because of the difference in capital
action assumptions. If the Fed believes a banks capital action is not robust to withstand stressful economic scenarios on quantitative
and qualitative grounds in a CCAR assessment, bank may not be able to engage in planned capital distribution and may have to resubmit
capital plans to the Fed.

Evolution of Regulations

After the 2009 financial crisis, regulatory bodies in the US realized existing regulations and stress-testing techniques were inefficient in
measuring a banks risk profile and resilience in sustaining itself during an economic crisis, which could strain its capital adequacy and
ability
to survive.

To make the supervisory process more robust, the Fed carried out an assessment of capital in 2009, called the SCAP (supervisory capital
assessment program), on the 19 largest US BHCs, which had weakened amid the financial and economic downturn.

The SCAP assessed whether the 19 BHCs had sufficient capital to absorb losses under a scenario more severe than the one in 2009. The
SCAP used two scenarios: baseline and more severe scenarios. Ten of the 19 BHCs failed the SCAP, as their capital was below the required
ratio. They were asked to prepare a new capital plan and raise the necessary capital to meet the target. SCAP test results reinstated
confidence in the public by reducing uncertainty about the health of BHCs, which helped stabilize the US financial system.

The results and analysis of SCAP helped the Fed initiate CCAR and DFAST in 2010 to ascertain the capital adequacy and capital planning
of large BHCs. BHCs with total consolidated assets of more than $50bn have to participate in the regulatory stress tests (CCAR and
DFAST). Banks with total consolidated assets of more than $10bn have to conduct their company-run stress tests under the same
supervisory scenarios, planning horizon, and capital actions assumed in DFAST.

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Process

CCAR and DFAST both assume the same set of scenarios (baseline, adverse, and severely adverse), macroeconomic shocks, and planning
horizon to evaluate the capital adequacy of a bank. The adverse and severely adverse scenarios are not forecasts, but hypothetical
scenarios developed by the Fed to gauge the impact of macroeconomic shocks on the stability of banks. The baseline scenario
assumes a profile similar to that used in the average projection of US real economic activity, inflation, and interest rates. Twenty-eight
macroeconomic variables are calibrated over a nine-quarter planning horizon under these three scenarios to project balance sheets,
RWAs, net income, and post stress capital levels and regulatory capital ratios. Of these 28 variables, 16 capture economic activity, asset
prices, and domestic interest rates in the US economy and real GDP growth, inflation, and US/foreign currency exchange rate in each of
the four countries/country blocs (eurozone, UK, Developing Asia, Japan).

Projections in CCAR and DFSAT vary, as their capital action assumptions are different. DFAST is a forward-looking quantitative assessment
with standardized capital action assumptions to measure stress capital adequacy ratios. All the participating BHCs have to maintain post-
stress capital ratios above the applicable minimum regulatory capital ratios during each quarter of the planning horizon of three years to
pass the stress test.

CCAR is a broader exercise; it covers the quantitative and qualitative assessments of a participating BHC. In the quantitative calculation,
supervisory post-stress capital analysis is based on the projections of net income, total assets, and RWAs. Macroeconomic shocks and
scenarios assumed in DFAST are calibrated by incorporating a BHCs capital planning and distribution to evaluate the BHCs capability to
adopt capital measures mentioned in the BHC baseline scenario.

Quantitative-assessment results also include BHCs internal stress tests under supervisory and the banks own scenarios. The Fed can
object to the capital plans of a BHC on quantitative grounds if the BHC is unable to maintain the minimum required capital ratio
throughout the planning horizon in post-stress capital analysis.

The qualitative assessment focuses on key areas, such as a BHCs risk management framework, control infrastructure, capital planning
and distributions, and internal capital planning process, to determine the sum and composition of capital a bank has to maintain
throughout the period of a severe economic crisis scenario. The supervisory test also evaluates the rationale behind a BHCs capital plan
and assumptions of the underlying capital plan. It also involves a BHCs material risk identification process and capital planning process to
evaluate specific risks faced by the bank under stress. Reasons for objections from the Fed on qualitative aspects include the following:
Material supervisory issues still unresolved
Unreasonable or inappropriate assumptions and analyses underlying the capital plan of a BHC
Unreasonable or inappropriate methodologies for reviewing the robustness of capital planning process of a BHC
Belief a BHCs planning process or capital distribution is unlawful or unsafe practices, which are not permitted by the Fed

Models used to ascertain the impact of stressful scenarios on balance sheets, RWAs, pre-provision net revenue PPNR, and projected losses
are developed or selected by the Fed. The same sets of models and assumptions are applied across all BHCs. The modeling approach is
forward-looking so that it integrates outcomes outside historical experience and is appropriately conservative and consistent with the
intent of the stress-testing exercise. Models used in supervisory stress tests are reviewed by an independent model validation team.

Key takeaways:
Supervisory stress-test models are developed by the Fed and are applicable to all participating BHCs. Banks also have to develop their
own models for company-run stress tests under the guidance of the Fed. Model development and scenario design exercise require
considerable expertise, along with functional knowledge of risk domain. For model development and scenario expansion, banks need
to consider all the granular risk variables and shocks specific to them.

8 CCAR Results 2016


CCAR/DFAST Framework 2016 vs 2015

Thirty-three large BHCs participated in the 2016 supervisory stress test compared with 31 BHCs in 2015. A detailed comparison of the 2016
and 2015 supervisory stress tests is provided below.

Key Model Changes


Operational risk: To improve the stability of a model and minimize year-over-year variation in projected losses, changes were made in
the risk projection methodology, with additional modifications in the historical simulation model to project operational risk losses. The
changes resulted in an increase in operational risk losses (as percentage of RWAs), effectively higher losses for firms reporting fewer tail
risks but still vulnerable to losses from such events.

MRWA Model: To better differentiate the sensitivity of each component to scenario variables and to align estimates more closely
to the market risk rule. The effect of changes could be seen in the positively correlated movement of incremental risk charge and
comprehensive risk measure with projected credit market volatility. The projected MRWA declined moderately in aggregate.

Supervisory Capital evaluation: Greater precision was incorporated in capital ratio denominator adjustments and in assumptions on
the relationship between mortgage servicing assets and the associated deferred tax liabilities. As a result, capital ratios fell, affecting
items fully deducted from regulatory capital.

DFAST 2016 vs DFAST 2015 Results

In aggregate, banks had a stronger balance sheet in 2016 than in 2015

Capital increased in 2016 with credit-quality improvement in some material loan portfolios
Results also showed reductions in illiquid securitization exposures on the trading books and projected losses due to mortgage-related
litigations and settlements
The 2015 severely adverse scenario consisted of, among others, assumptions of corporate credit quality worse than the severe
recession, which amplified already widening corporate bond spreads, a decline in equity prices, and an increase in equity price volatility.
The severely adverse scenario in 2016 included a severe recession and negative short-term interest rates, limiting the decline in equity
prices and the increase in market volatility
Changes in the scenario were expected to increase projections for net income in the aggregates in 2016. However, the effects were
varied across firms
With lesser stress in equity markets in 2016, firms active in trading and market activities saw smaller losses in net income, while firms
involved in more traditional lending activities were affected more from negative short-term rates and greater stress in the
real economy

CCAR 2016 vs CCAR 2015

The Fed has continually raised the bar on process enhancements that it expects BHCs to meet the requirements through stronger
frameworks. The 2016 stress test was more stringent than previous stress tests
Overall, capital adequacy levels of the participating BHCs improved from 2015
Even though all BHCs (except a couple of them) improved their capital planning compared with 2015, qualitative deficiencies were
observed in their planning process
For the second straight year, Santander and Deutsche Bank received Objection to Capital Plans owing to their weak risk management
framework, governance, and oversight
In 2015 Bank of America received Conditional Non-Objection, based on its weakness in estimate modeling practices. This year
(2016), Morgan Stanley has been given Conditional Non-Objection owing to weaknesses in its scenario design, modeling, and
governance and control practices

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Graphical Comparison of Stress Scenario Severity
A simplistic comparison of the severity of the stress scenario between 2015 and 2016 (severely adverse scenario) is provided below. Only
projections have been compared. Q1 2016 to Q4 2018 values in the 2016 stress test are compared with Q1 2015 to Q4 2017 values in
the stress test in 2015. The quarters in 2016 are compared with their respective quarters in the 2015 scenario, for example, Q1 2016 is
compared with Q1 2015 in the 2015 scenario. The comparison leads to the conclusion the 2016 scenario is more severe than the
2015 scenario.

Economic Activity

Real GDP growth (in %) Nominal disposable income growth (in %)


5 6

4
0
Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Q9 Q10 Q11 Q12 2

0 2016
-5 2015
-2
2016 Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Q9 Q10 Q11 Q12
-10 2015 -4

Unemployment rate (in %) CPI inflation rate (in %)


15 4

3
10
2
5
Unemployment 2016 DFAST 1 2016
Unemployment 2015 DFAST 2015
0 0
Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Q9 Q10 Q11 Q12 Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Q9 Q10 Q11 Q12

Interest Rate

3-month Treasury rate (in %) BBB corporate yield (in %)


0.2 8

0 6
Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Q9 Q10 Q11 Q12
-0.2 4
2016
-0.4 2 2016
2015
2015
0
-0.6 Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Q9 Q10 Q11 Q12

Mortgage rate (in %) Prime rate (in %)


6 4

3
4
2
2 2016
2016 1
2015 2015
0 0
Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Q9 Q10 Q11 Q12 Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Q9 Q10 Q11 Q12

10 CCAR Results 2016


Asset Prices

Dow Jones Total Stock Market Index (level) House Price Index (level)
25,000.00 200
20,000.00 150
15,000.00
100
10,000.00
5,000.00 2016 50 2016
2015 2015
0.00 0
Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Q9 Q10 Q11 Q12 Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Q9 Q10 Q11 Q12

Commercial Real Estate Price Index (Level) Market Volatility Index (Level)
300 100
2016
2015
200
50
100
2016
2015
0 0
Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Q9 Q10 Q11 Q12 Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Q9 Q10 Q11 Q12

Key takeaways:
Over time, stress tests are not only becoming more sophisticated but also covering a broader range of risk variables at more severity
levels. Banks need to focus strongly on stress-testing exercises every year to ensure the smooth functioning of the business and
financial sta bility.

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EBA
Stress testing for banks and financial institutions under the purview of the EU financial market is overseen and supervised by the EBA. The
EBA an independent EU authority oversees the EU banking sector to ensure financial stability in the EU and safeguard the integrity,
efficiency, and functioning of the banking sector.

The EBA helps create the European Single Rulebook in banking, which provides a single set of prudential rules consistent for all EU
financial institutions under its purview. The association also promotes convergence in supervisory practices and assesses risks and
vulnerabilities across the institutions in the EU banking sector. This is carried out regularly in the form of stress testing in these institutions,
duly supervised by the EBA.

In what follows, we look at the evolution of the EU regulatory environment and the birth of the current regulations.

Evolution of Regulations
The Council of European Union issued Capital Adequacy Directive (1993) and implemented it in 1995. Targeting banking and
nonbanking firms, the directive was meant for banks to calculate their capital estimate using VaR techniques. It was revised twice, in
1998 and in 2006, with CAD renamed to capital requirement directive (CRD).
The CRD was introduced in 2006 to incorporate Basel II guidelines, which resulted in the introduction of the CRD I package. The CRD
II and CRD III packages were adopted in 2009 and 2011, respectively. 2013 saw the transposition of the CRD IV package with the
incorporation of Basel III guidelines under the name Capital Requirements Regulation (CRR) and Directive (CRD IV).
The Committee of European Banking Supervisors (CEBS), an independent advisory group on banking supervision in the EU, was
established in 2004 under the European Commission, with a revised charter in 2009. The role involved advising the European
Commission on measures on lending activities, contributing toward the implementation of directives and practices, and improving
supervisory cooperation including the exchange of information. Stress tests were started in 2009, and the second edition was
conducted in 2010, after which the CEBS was superseded by the EBA under European Supervisory Authorities (ESA), formed as a part
of the European System of Financial Supervision (ESFS) framework for Financial Supervision (in operation since 2011) and developed
through the Lamfalussy Process after the 2009 financial crisis.
The main role of the EBA comprises the creation of the European Single Rulebook in banking, which provides a set of standard rules for
financial institutions throughout the EU, creating a level-playing field and providing protection to consumers, depositors, and investors.
Other tasks include the promotion of practices toward the application of rules, assessment of risks and vulnerabilities in the banking
sector, and other activities involving the maintenance of the health of the EU banking sector.

Process

The 2016 EU-wide stress testing of banks was the fifth edition of the regulatory exercise. The first test was conducted in 2009. The stress
test is similar to those conducted in other financial systems across the globe, with the tests involving baseline and severe scenarios to
arrive at capital ratios and values, which can be compared with the regulatory required capital adequacy ratios and hurdle rates. The
regulatory authorities recommend, through feedback and suggestions, actions to be taken by the firms that pass or fail these tests.

After the 2009 and 2010 stress tests under CEBS, the EBA came into existence in 2011. The ESFS framework for financial supervision,
implemented in 2011, was proposed by the European Commission after the 2009 financial crisis. It includes ESA, European Systemic Risk
Board (ESRB), Joint Committee of the ESA, and the national supervisory authorities of member states.

The ESFS framework includes microprudential and macroprudential oversights at the EU level. The ESA, the Joint Committee of ESA, and
the competent national supervisory authorities are responsible for microprudential oversight. The ESA comprises European Securities
and Markets Authority (ESMA), European Insurance and Occupational Pensions Authority (EIOPA), and the EBA. The ESRB is responsible
for macroprudential oversight of the ESFS framework and includes representatives from the European Central Bank (ECB), supervisory
authorities in national central banks of EU member states, and the European Commission.

The regulatory process involves the EBAs devising a methodology applicable to all banks undergoing the tests and checked by the
supervisors. The competent authorities are responsible for quality assurance and supervisory reaction functions. The ESRB designs
common adverse scenarios for stress tests, while the European Commission provides the baseline scenario. The EBA also provides EU
descriptive statistics on risk parameters for consistency checks in addition to acting as a data hub for the final dissemination of the
common exercise to ensure transparency and proper comparison, as well as proper coordination and communication among the various
entities for the exercise.

In the 2011 and 2014 stress tests, the methodology included the assessment of banks involved on the basis of capital shortfalls, labeling
them as pass or fail, followed by appropriate actions. From 2016, the methodology has changed toward assessing the banks on their
forward-looking capital planning. Even though hurdle rates and capital thresholds have been done away with, the results of the latest tests
would be used as inputs for the supervisory review and evaluation process (SREP), which would help authorities decide on Pillar 2 capital
requirements. Additional risk drivers, especially operational and conduct risks, have been included.

12 CCAR Results 2016


Further, for greater homogeneity and comparability, the sample size has been reduced to 51 banks (representing 70% of banking sector
assets in the eurozone, non-eurozone EU member states, and Norway). Criteria for inclusion in the sample included a minimum total
consolidated asset size of EUR20bn, consistent with the criterion used for inclusion in a sample of banks reporting supervisory data to the
EBA. There was scope for including additional institutions and banks on the request of competent authorities, provided the institutions
held more than EUR100bn in assets and mandatory restructuring plans (agreed by the European Commission).

Key takeaways:
The SREP is a mechanism under Pillar 2 capital requirements that ensures institutions have adequate arrangements, approaches,
procedures, and mechanisms, as well as capital and liquidity, for the sound management and coverage of their own risks to which they
are or might be exposed to, including those revealed by stress testing and risks they may pose to the financial system.

Unlike in the US supervisory stress test, banks have to develop their own models to assess the impact of stressed scenarios on credit,
market, and operational risks. The models are developed under the guidance of regulatory bodies and are subject to a number of
conservative constraints. Banks need to include all material risk factors while developing the models.

EU-wide Stress Test Framework 2016 vs 2014

In the 2016 stress test, 51 banks were assessed, which represented 70% of the EU banking assets (compared with 123 banks in 2014).

Pass-fail criteria were not included in 2016, whereas the criteria for passing the test in 2014 included capital hurdle rates of 8% common
equity Tier 1 (CET1) in baseline and 5.5% CET1 in adverse scenarios.
2016 saw the inclusion of the impact of risk drivers under credit, market, and operational risks. Common risks included in the 2014 edition
were credit, market, sovereign, securitization, and cost of funding risks while operational and conduct risks were excluded.

The treatment of FX lending has been explicitly added in the scope of the 2016 exercise. Banks that had significant foreign currency
exposure (above the threshold limit) were asked to include the altered creditworthiness of their respective obligors by evaluating
exposures denominated in foreign currency of the borrower at the asset class level for each country of counterparty in the 2016 stress test.

Similar to the 2014 stress test, the assessment of the impact of risk drivers on the solvency of banks has been the primary focus of the
2016 stress test. A static balance sheet has been assumed over the time horizon of three years, with the same business mix and model,
zero growth, and no capital measures in the 2016 EU-wide stress test, similar to the 2014 stress test.
The adverse scenario in the 2016 stress test is stricter than that in the 2014 test, as it includes more risk coverage and conservative
elements. The shocks have been front-loaded, which ensures the adverse impact materializes earlier during the test horizon.

In the 2016 stress test, the ECB perceived the current level of capitalization in the euro banking system to be satisfactory. Therefore, the
intent of the 2016 exercise focused more on assessing the remaining vulnerabilities and the impact of a hypothetical adverse market
scenario on banks. The 2014 stress test consisted of an asset quality review and a supervisory stress test aimed at determining possible
capital shortfalls and ascertaining whether any banks needed immediate recapitalization measures.

Modifications in the Pillar 2 structure, including a breakdown into Pillar 2 requirements and Pillar 2 guidance, imply that results of 2016
EU-wide stress test are not directly comparable with the SREP 2015. Therefore, previous comprehensive assessments are quite different
from those in the 2016 stress test.

Overall, the banks tested in 2016 have been found to be more resilient than those in the 2014 test. Twenty-four of the 123 banks that
participated in the 2014 stress test failed. This year, results exhibit resilience in the EU banking sector as a whole.

Moodys Analytics Knowledge Services 13


Results of 2016 EBA Stress Test

Transitional CET1 capital ratio - Top 5 Transitional CET1 capital ratio - Bottom 5
30.00% Starting 2015 50.00%
42.82% Starting 2015
25.00% Baseline 2018 40.00% 39.44% Baseline 2018
26.44% Adverse 2018 35.40%
Adverse 2018
20.00% 16.58% 24.14% 22.26% 16.78% 19.85% 30.00% 28.05%
24.67%
15.00% 14.31% 14.30% 14.74% 15.53% 16.06% 14.00% 20.00% 17.62% 15.89%
13.27% 11.45% 13.54% 15.54% 8.08%15.86%16.97% 12.01% 12.04%
10.00% 10.00% 7.39%
-2.23%
5.00% 0.00%
0.00% -10.00% BNG NRW Bank RBS Allied lrish BMPS
DNB PKO Bank Swedbank Credit Jyske Bank
Polski Mutuel

Transitional leverage ratio - Top 5 Transitional leverage ratio - Bottom 5


8.00% 7.30% Starting 2015 12.00%
Baseline 2018 Starting 2015
7.00% 6.39% 6.35%
Adverse 2018 10.00% 8.91% Baseline 2018
5.61% 9.97%
6.00% 4.93% 5.22%
5.19%
5.06% 8.00%
8.21%
9.20%
Adverse 2018
4.76% 4.97% 7.91%
5.00% 4.82% 4.21% 6.64% 6.61%6.56%
4.41% 4.41% 4.40% 6.00% 4.53%
5.79%
4.00% 4.19% 4.76%
5.22% 5.16%

3.00% 4.00%
2.00% 2.00%
1.00% 0.00% -0.65%
-2.00% Bank of
Handelsbanken DNB SEB Swedbank Nykredit Ireland OTP RBS Allied lrish BMPS

Key takeaways:
There are major changes in the 2016 stress test framework compared with the previous stress tests conducted by the EBA. Banks have
a steep learning curve to cope with in the new regulatory regime.

14 CCAR Results 2016


UK PRA
Stress testing for banks and financial institutions under the purview of the UK financial market is overseen and supervised by the Bank of
England (BoE) and the PRA. The Financial Policy Committee (FPC) was established in 1998 primarily to help achieve the BoEs objective
of financial stability, including in growth and employment levels, in the UK while identifying, monitoring, and taking actions to remove or
reduce the effect of systemic risks, thereby enhancing the robustness of the UK financial system. In 2013, the FPC had asked the BoE and the
PRA to propose steps for stress testing the UK banking system at regular intervals. These tests would help assess the capital adequacy of the
UK financial system. Similar to stress tests elsewhere, these tests provide a quantitative, forward-looking assessment of a financial system.

In what follows, we discuss the evolution of the UK regulatory environment and the birth of the current regulations.

Evolution of Regulations

Under Financial Securities Act 1986, the Securities and Investments Board Ltd (SIB) was incorporated, which oversaw and presided over
various self-regulating organizations (SROs) using a mix of governmental regulations and self-regulations. A series of scandals, especially
culminating in the collapse of Barings Bank, led to the realization for the need to end self-regulation of the financial industry and consolidate
the regulatory responsibilities split across multiple regulators. The SIB revoked The Financial Intermediaries, Managers and Brokers Regulatory
Associations (FIMBRA) status as an SRO in 1994, and members were moved into Personal Investment Authority (PIA).

In 1997, the SIB was renamed Financial Services Authority (FSA), and its powers were expanded through Financial Services and Markets Act
2000. In addition to regulating financial firms, insurance companies, and financial advisors, it started to regulate mortgage businesses from
2004 and general insurance intermediaries from 2005. Following the worldwide regulatory failure of the banks during the 2009 crises, the
UK government decided to restructure the financial regulations and abolish the FSA. It passed the Financial Services Act 2012 through Royal
assent, and it was announced that the responsibilities of FSA would be delegated to a number of new agencies, viz. the Financial Conduct
Authority (FCA), the PRA, and Bank of England.

According to the Financial Services Act 2012, the FCA would monitor the financial activities of the banking system, while the PRA would
regulate financial firms, including banks, investment banks, building societies, and insurance companies. In its current capacity, the FCA
regulates financial firms, focusing on regulating the conduct of wholesale and retail financial services providers, especially those involved
in marketing financial products. It can specify minimum standards, specify requirements of products, and investigate organizations and
individuals, thus maintaining the integrity of the UK financial market. On the other hand, the PRA establishes standards and oversees
financial institutions at an individual level. Its role is primarily defined in terms of three statutory objectives:
Promoting the safety and soundness of firms it regulates,
Supervising insurance firms to safeguard the interest of policyholders,
Facilitating effective competition
Regarding the promotion of safety and soundness, the primary focus is on the harm firms can cause to the integrity and stability of the UK
financial system.

The UK Parliament recently passed the Bank of England and Financial Services Act 2016. The act puts the BoE at the center of UKs economic
and financial systems by making it better equipped to fulfil the vital role of overseeing monetary policy and financial stability in the UK.

Process

The 2016 stress testing of banks and financial systems under the UK financial system is the third edition of the regulatory exercise, with the
first set of tests performed and results published in 2014. The stress test of UK firms involves an evaluation similar to the assessment of their
US and European counterparts, with the tests around baseline and severe scenarios and testing criteria involving capital adequacy ratios
and hurdle rates. Actions to be taken by the firms that pass or fail the tests are based on qualitative assessments, involving feedback and
suggestions, by the regulatory authorities.

In 2013, the BoE, under the guidance of the FPC and the PRA Board, released a paper A framework for stress testing the UK banking
system, to discuss the appropriate design framework for the tests in the medium term. Regarding the frequency and timeliness of tests,
the framework suggests that the regularity of the tests is important since these tests represent an important assessment of the stability of
the financial system. Hence, the frequency of the tests should be annual, as this would encourage the firms and the authorities to invest
continually in stress-testing capabilities. Further, the focus would be on guarding against risk illusion, forcing the firms to consider the
types of risks that threaten their stability. Regarding concurrency, it is important to conduct the tests for all firms in parallel, as the resilience
of a system is tested on a whole and allows the authorities to check for any amplification factors to risk and carry out changes and revisions
to the approach, strengthening the exercise on the whole. Stress Test results are published 6-7 months after balance sheet information has
been used as inputs, in line with the practice in the US, as the inputs are relevant and the analysis performed can be rigorous in nature.

Moodys Analytics Knowledge Services 15


Regarding the coverage of the tests, banks and firms are included on the basis of three main considerations:

Importance to financial stability in the UK


Legal and regulatory status, which allows the FPC and the PRA to take appropriate actions (depending on the results)
Activities, which should be sufficiently similar so that the framework can be kept simple and no separate analytical toolkits would need to
be developed

Based on the above, the stress-testing exercise would include major UK banks (ranked on the basis of asset size, with a threshold of GBP50bn).
Additionally, the merits of including medium-sized banks have been recognized, with the option of either including them in the framework but
performing only limited scenario tests or not including them, but keeping the framework flexible.

For scenario-building, the framework points out the tests need to be conducted, in general, on:

Common scenarios, applied across all banks undertaking the stress tests, designed by the FPC in consultation with the PRA (This would
include a common baseline scenario and a common stressed scenario.)
Bespoke scenarios designed by the banks and approved by the PRA Board, with severity matching with at least the common scenarios of
the FPC

For modeling the scenarios, the framework suggests the use of a suite of models, calibrating the macroeconomic and market variables to
estimates of banks profitability and capital ratios. This makes sense, as it is not easy to realistically capture all risks through a single model,
which may even give rise to model risk. Furthermore, different models bring different insights and perspectives and provide an array of
mediums to cross check the results and prevent manipulation. With this objective, the framework suggests using four broad models:

Granular, regulator-developed stress-testing models


Coarser, system-wide stress-testing models
Banks own stress-testing models
Other satellite models

Key takeaways:
Unlike the US and EBA stress tests, final projections are evaluated using both company-developed models and models developed by
the regulator in the PRA assessment.

Internal models would cover material risks specific to a bank and ensure improvements in its risk management and modeling
capabilities, while regulatory models cross check the results of banks and ensure consistency across banks.

16 CCAR Results 2016


PRA Framework 2014 and 2015 vs 2016

The results of the 2016 test are yet to be published. 2014 and 2015 had similar features, but the 2016 test has certain key differences from
the previous two years:

Similar to 2015, 2016 covers seven major UK banks (vs eight in 2014).
2014 and 2015 covered baseline and stress scenarios, whereas in 2016, in an updated approach for stress testing, the BoE devised an
annual cyclical scenario (ACS) to assess risks associated with conditions in credit, financial, and other asset markets. The ACS covers
both adverse and baseline scenarios. A second type the exploratory scenario, expected to be used from 2017 seeks to probe the
resilience of the system to risks emerging as threats to its financial stability.
The 2014 stress test mainly focused on domestics risks related to UK households and unemployment levels as a result of a sharp rise
in interest rates. The 2015 stress test delved more on global risks associated with a pronounced contraction in growth in the euro area,
other emerging market economies, and China. A broader range of domestic and global risks has been incorporated in the 2016 stress
test calibrated under the ACS framework compared with previous stress tests.Some global shocks under the ACS framework are akin to
the 2015 stress test, and some domestic shocks (GDP and unemployment levels) in the 2016 stress test are related to the 2014 stress
test. The scenarios in the 2016 stress test are more severe than those in the 2015 and 2014 stress tests.
Similar to 2015, the time horizon for 2016 is five years (vs three years in 2014).
Another major change was in the hurdle rate framework. In 2015, the threshold for capital requirement for risk-based capital was 4.5%
of RWAs, to be met with CET1 for RWAs, while adequacy for leverage terms, to be met with Tier 1, was 3% of the leverage exposure
measure. In 2016, apart from the 4.5% CET1, which is a Pillar 1 requirement, Pillar 2A capital has been included to mitigate the risk not
covered by Pillar 1. A minimum Tier 1 leverage ratio of 3% in an adverse scenario is required. Additionally, a second inclusion is based
on Systemic Reference Point, where G-SIB buffer is included, where capital requirement would increase the hurdle rates in a phased
manner, in increments of 25% each year.
In the 2014 stress test, the PRA Board concluded three (The Cooperative Bank, the Royal Bank of Scotland Group, and Lloyds Banking
Group) of the eight banks needed to improve their capital plan. The Cooperative Bank was asked to resubmit its capital plan. In the
2015 stress test, the PRA Board concluded two of the seven banks had capital inadequacy. But since these banks had already taken
measures to improve their capital position, they were not required to submit a revised capital plan.

Comparison between Baseline Scenario and Stress Scenario

A comparison of the severity of the stress scenario with respect to the baseline scenario is provided below. Both historical data and
projections have been taken into account to analyze the severity of the stressed variables with respect to the baseline scenario as well as
historical numbers. Data from Q1 2000 to Q4 2015 are historical values and data from Q1 2016 to Q4 2020 are projections.

UK real GDP 160.0


UK CPI
600,000
140.0
500,000
120.0
400,000 100.0
300,000 80.0
60.0
200,000
Baseline UK real GDP 40.0 Baseline UK CPI
100,000 Stress UK real GDP 20.0 Stress UK CPI
Q1 2000

Q1 2008
Q1 2004

Q1 2006
Q1 2003

Q1 2009
Q1 2005
Q1 2002

Q1 2020
Q1 2000

Q1 2008

Q1 2007
Q1 2004

Q1 2006
Q1 2003

Q1 2009
Q1 2005
Q1 2002

Q1 2020

Q1 2001

Q1 2010

Q1 2018
Q1 2014
Q1 2007

Q1 2016
Q1 2013

Q1 2019
Q1 2015
Q1 2012
Q1 2001

Q1 2010

Q1 2018

Q1 2017
Q1 2014

Q1 2016
Q1 2013

Q1 2019
Q1 2015
Q1 2012

Q1 2011
Q1 2017
Q1 2011

UK unemployment rate UK corporate profits


10.00 300,000

8.00 250,000

200,000
6.00
150,000
4.00
100,000
Baseline UK unemployment rate Baseline UK corporate profits
2.00 50,000
Stress UK unemployment rate Stress UK corporate profits
Q1 2000

Q1 2008
Q1 2004

Q1 2006
Q1 2003

Q1 2009

Q1 2000

Q1 2008
Q1 2005

Q1 2004
Q1 2002

Q1 2020

Q1 2006
Q1 2003

Q1 2009
Q1 2005
Q1 2002

Q1 2020
Q1 2007

Q1 2007
Q1 2001

Q1 2010

Q1 2018
Q1 2014

Q1 2016
Q1 2013

Q1 2019

Q1 2001

Q1 2010

Q1 2018
Q1 2015

Q1 2014
Q1 2012

Q1 2016
Q1 2013

Q1 2019
Q1 2015
Q1 2012
Q1 2017

Q1 2017
Q1 2011

Q1 2011

Moodys Analytics Knowledge Services 17


100
200
500

300
600

400

10.0
70.0

20.0
50.0

30.0
60.0

40.0

18
120.0

100.0

20.0
60.0

40.0
80.0
Q1 2000 Q1 2000 Q1 2000

100,000
200,000
500,000

300,000
400,000
Q1 2001 Q1 2001 Q1 2001 Q1 2000
Q1 2001
Q1 2002 Q1 2002 Q1 2002
Q1 2002
Q1 2003 Q1 2003 Q1 2003
Q1 2003
Q1 2004 Q1 2004 Q1 2004
Q1 2004
Q1 2005 Q1 2005 Q1 2005
Q1 2005
Q1 2006 Q1 2006 Q1 2006
Q1 2006
Q1 2007 Q1 2007 Q1 2007
Q1 2007
Q1 2008 Q1 2008 Q1 2008
Q1 2008
Q1 2009 Q1 2009 Q1 2009
Q1 2009
Q1 2010 Q1 2010 Q1 2010
Q1 2010
Q1 2011 Q1 2011 Q1 2011
Q1 2011
Q1 2012 Q1 2012 Q1 2012

Volatility index
Q1 2012

Euro area real GDP


Q1 2013 Q1 2013 Q1 2013
UK household income

Q1 2013
Q1 2014 Q1 2014 Q1 2014 Q1 2014
Q1 2015 Q1 2015 Q1 2015
Sterling IG corporate bond spread

Q1 2015
Q1 2016 Q1 2016 Q1 2016 Q1 2016

real GDP
real GDP
Q1 2017 Q1 2017 Q1 2017 Q1 2017
Stress Sterling IG
Baseline UK household income
Stress UK household income

Baseline Sterling IG

Stress Euro area


Stress Volatility index
Baseline Volatility index
Q1 2018 Q1 2018 Q1 2018

Baseline Euro area


corporate bond spread
corporate bond spread

Q1 2018
Q1 2019 Q1 2019 Q1 2019 Q1 2019
Q1 2020 Q1 2020 Q1 2020 Q1 2020

7.00

1.00
2.00
5.00

3.00
6.00

4.00
120.0
140.0

100.0

20.0
60.0
40.0
80.0

120.0
120.0

160.0
140.0
140.0

100.0
100.0

20.0
20.0

60.0
60.0

40.0
40.0

80.0
80.0

Q1 2000 Q1 2000 Q1 2000 Q1 2000


Q1 2001 Q1 2001 Q1 2001 Q1 2001
Q1 2002 Q1 2002 Q1 2002 Q1 2002
Q1 2003 Q1 2003 Q1 2003 Q1 2003
Q1 2004 Q1 2004 Q1 2004 Q1 2004
Q1 2005 Q1 2005 Q1 2005 Q1 2005
Q1 2006 Q1 2006 Q1 2006 Q1 2006
Q1 2007 Q1 2007 Q1 2007 Q1 2007
Q1 2008 Q1 2008 Q1 2008 Q1 2008
Q1 2009 Q1 2009 Q1 2009 Q1 2009
Q1 2010 Q1 2010 Q1 2010 Q1 2010
Q1 2011 Q1 2011 Q1 2011 Q1 2011
Q1 2012 Q1 2012 Q1 2012 Q1 2012
Q1 2013 Q1 2013 Q1 2013 Q1 2013
3 month sterling Libor

Q1 2014 Q1 2014 Q1 2014 Q1 2014


PPP-weighted World real GDP

GBP-USD exchange rate index

Q1 2015 Q1 2015 Q1 2015 Q1 2015


Q1 2016 Q1 2016 Q1 2016 Q1 2016
Q1 2017 Q1 2017 Q1 2017 Q1 2017
World real GDP
World real GDP

sterling Libor
sterling Libor
Stress GBP-USD
Stress UK commercial real

Stress PPP-weighted

Stress 3 month
UK commercial real estate price index - aggregate

Baseline GBP-USD
Baseline UK commercial real

Q1 2018 Q1 2018 Q1 2018 Q1 2018


Baseline PPP-weighted

Baseline 3 month
exchange rate index
exchange rate index
estate price index - aggregate
estate price index - aggregate

Q1 2019 Q1 2019 Q1 2019 Q1 2019


Q1 2020

CCAR Results 2016


Q1 2020 Q1 2020 Q1 2020
Conclusion
Following the 2009 crisis, stress testing has become one of the most important tasks for banks. To ensure financial stability and
confidence among investors and the general public, banks need to undergo rigorous stress tests, in which their capital adequacy is
evaluated under hypothetical severe scenarios. These scenarios are more severe than the historical crises that shook the world. The
rationale behind these stress tests is to ensure such events do not recur and deteriorate the economy.

Supervisory bodies around the world have adopted sophisticated stress-testing methodologies to evaluate financial-system resilience.
These bodies have developed common risk factors and scenarios applicable to all banks in an economy. In addition, banks need to develop
their own scenarios to evaluate risks specific to them. Not only do supervisory authorities develop models to calculate the impact of risk
factors on the balance sheet and profits, but banks also need to develop their own models to cover firmwide risks under the guidance of
regulators. With changes occurring in the regulatory environment every year, banks need to adapt to the new rules and regulations by
improving their risk framework.

To adapt to the new regulatory regimes, banks have started outsourcing the task of stress testing. Outsourcing firms with expertise in
regulatory environments are able to help banks better understand regulatory requirements. This has helped banks identify all material
risks specific to them and create better risk models and scenarios for better capital planning and control.

Stress testing is not limited to stressing on macroeconomic variables in hypothetical scenarios; it also requires a bank to improve its risk
assessment and modeling capabilities, capital planning, and reporting and accounting standards. Risk assessment exercises performed by
banks cannot be improved drastically overnight; they are enhanced gradually in phases. Banks need to gain insights into their strengths
and weaknesses to improve their risk assessment and modeling practices; this would, in turn, improve the quality of their stress-testing
capabilities.

There are key differences in the risk framework and guidelines of regulatory bodies around the world, but the core activities of banks and
the challenges they face are similar. The primary activities of banks require expertise in scenario development, data management, model
development and governance, revenue and balance sheet modeling, loss forecasting, process reengineering, and documentation. Other
than supervisory scenarios, banks have to design internal scenarios. Scenario expansion requires breaking down macroeconomic variables
into granular risk factors specific to a bank. Revenue and balance sheet modeling requires consistency in assumptions across the balance
sheet and the need to capture contagion effects of modeling. Banks need to adhere to the model risk management guidelines issued by
their regulators; they also need to continually improve their existing models by developing challenger models. In addition, models need to
be comprehensively documented to include descriptive analysis of model methodology, assumptions, requirements, and model validation
results.

From our experience, we can infer stress testing is likely to remain one of the most important tasks for banks and regulatory requirements
would continue to increase over time. Regulators have been closely monitoring banks risk assessment capabilities since 2009 crisis,
and passing stress tests has become imperative for the smooth functioning of banks. This is why banks need to ensure stress testing
is one of their primary objectives. The latest results of stress tests show various large banks around the world are resilient to adverse
macroeconomic scenarios, but banks still need to keep pace with increasing regulatory requirements. The road to success lies in improving
their ability to identify and mitigate risks.

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