Regional Training on Micro Prudential Stress Testing
METACBeirut, Lebanon 20th – 24th Feb 2017
Day 1, Session 2Introduction to Stress Testing
Michael Lau, consultant LA
Introduction
• The meaning of stress testing
• Parallel developments
• Evolution of Stress testing Guidelines and Practices
• Next Steps
• Overview of the stress testing process
• Selected models
2
What are stress tests
1. They are an assessment of the impact(s) of hypothetical change
2. Are a forward looking measure (cf with FSIs which are backward looking)
3. Can produce an outcome measured in terms of a single metric (eg capital adequacy) or multiple metrics (eg FSI’s or even fully integrated financials)
4. Can test a product, a business unit, an entity, portfolio of common elements (eg industry sectors), or a banking system as a whole
5. Can test credit, market, operational, liquidity and other risk (eg reputation)
6. Can be quantitative, qualitative or a combination of both
7. Can use one or more of many available methodologies
8. Can require small or large amounts of data depending on test applied
9. Can be run routinely or at ad hoc intervals
10. The is no right way to stress test, each method will have advantages and disadvantages
11. Test should apply the Principle of Proportionality (ie level of testing and analysis should related to the size, complexity and level of risk taking)
12. Financial sector stress testing is constantly evolving (eg attention to liquidity solvency interaction, feedback effects, and non linearities)
Stress Testing Timeline*
Date Banking Regulation Stress Testing (advanced) Stress Testing (emerging)
Pre
1988
No broad banking regulation No common stress testing
practices
Sensitivity testing for Market
Risk
Ad hoc regulation Market risk sensitivity testing
Market risk VAR testing
Interest rate risk sensitivity
Monte Carlo simulations
1988 1st Basel Accord (Basel I)
consultations
No requirements for credit
stress testing
Sensitivity testing for Market
Risk continues
Capital calculations Led by product development
1992 1st Basel Accord (Basel I)
becomes effective
No requirements for credit
stress testing
Used for product signoffs
2004 2nd Basel Accord (Basel II)
consultations
Still largely independent
development by banks
Basel I adopted. No
requirement for stress testing
Focus on credit risk Developing requirements for
Credit Risk testing
Some discretionary credit risk
stress testing
Intro of Market Risk Capital Market Risk testing as above VAR used for market risk
Intro of Operating Risk Capital Introduction of Op Risk testing No operating risk testing
* Note that the stress testing comments are intended to align with the year and not the Banking regulation
Stress Testing Guidelines and Practice (continued)
Date Banking Regulation Stress Testing (advanced) Stress Testing (emerging)
2006 2nd Basel Accord (Basel II)
becomes effective
Requirements for Credit risk
capital
Requirements for “rigorous
forward looking” Credit Risk
stress testing
Basel II not adopted by emerging
countries. Continued growth of
sensitivity testing for credit risk
Requirements for Market
Risk capital
Requirements for Market Risk
stress testing
Use of simple VAR for Market Risk
Requirements for Operation
Risk capital
Slow development of Operating
Risk Stress testing techniques
No requirement but some
development of Op risk testing
AIRB methods for Credit Risk
and some advanced methods
for Op Risk
Globally active banks
•Sensitivity testing (single period)
•Scenario testing (single & multi
period)
•Extensive data histories available
•Complex quantitative models
used
Stress Testing Guidelines and Practice (continued)
Date Banking Regulation Stress Testing (advanced) Stress Testing (emerging)
2006 Core Principles for Effective
Banking Supervision - Consult
Designed to cover all banks Banks would be required to
have forward-looking stress
testing programmes
Concepts selectively adopted in
basic form.
Models still mainly sensitivity
testing
Emphasises proportionality To be commensurate with risk
profile & systemic importance
Requirement to stress credit,
market liquidity and op risk
2008 Global Financial crisis
Complex models often failed to
capture risks (esp tail risks):
Continued experimentation with
sensitivity testing
Unrecognised contagion risks Similar banking weaknesses but
Poor governance practices Less complex banking sectors
Unrecognised concentrations Less interbank exposures
Unrecognised non linearities Less wholesale funding
Unrecognised liquidity risks Stress testing failure not so great
Lack of integration of risks
Weak valuation processes
Evolution of Stress Testing (continued)
Date Banking Regulation Stress Testing (advanced) Stress Testing (emerging)
2008 Principles of Sound Liquidity
Risk Management
Revised stress testing
requirements
New stress testing requirements
targeted at advanced banks only
Test for ratios Concepts selectively adopted
2009 Revisions to the Basel II
Market Risk framework
2009 US Supervisory Assessment
Program tests (SCAP)
Obliged to build capabilities
2009 Principles for Sound Stress
Testing
50% of countries perceived to be
at an “early stage”
Principles are relevant for emerging markets
(see next slide) Continuing development of
complex quantitative models
Continuing development of simple
single period sensitivity testing
Focus on individual risks in silos Only limited multi period testing
Limited use of integrated P&L
and BS approaches
Focus on solvency testing through
impact on CAR
Testing for PD and LGD
migration, correlations and
concentrations
Testing liquidity including funding impacts
Evolution of Stress Testing (continued)Date Banking Regulation Stress Testing (advanced) Stress Testing (emerging)
2010 First EBA Stress Tests2010/11 3rd Basel Accord (Basel III)
Leverage ratio Revision of section in Basel II on
stress testing
Basel III not being adopted but
providing a useful reference
Tier 1 increase (CEq) Qualitative requirements when
using IR models is expanded
Still using simple models.
Limited by availability of data
Other Tier 1 increase Monthly stress testing of market
risk exposures
Credit risk testing for impacts
on NPLs, large exposures etc
Capital Conservation buffer
(CEq)
Requirement for multi factor
scenario testing including non
directional risk testing
More scenario based sensitivity
testing on credit, interest rate
and FX risk
SIFI surcharges (CET1 req) Extreme but plausible events Limited by data availability
Counter cyclical buffer (CEq) Reverse stress testing
Liquidity Coverage Ratio (LCR) Testing of market movements on
exposures and counterparty
credit worthiness
Some attempts at adoption of
Basel III liquidity ratios.
Net Stable Funding Ratio
(NSFR)
Testing of large exposures,
concentrations and correlations
Global banks are undertaking
own stress testing
Stronger treatment for
securitisation, trading &
derivatives
Senior management to take a
lead role in the stress test
management framework
Basic in house models used.
Some transfer of stress testing
knowledge between banks
Evolution of Stress Testing (continued)
Date Banking Regulation Stress Testing (advanced) Stress Testing (emerging)
2011 Second EBA Stress Tests
US CCAR & CPAR Stress Tests
2012 Core Principles for Effective
Banking Supervision
becomes effective
Requirement for forward looking
stress testing commensurate
with risk profile and systemic
importance
Continued development of
simple in house models, still
largely excel based single period
models
Requirement to adopt plausible
adverse scenarios
Bank to integrate results into
decision making and risk
management
Some Central banks using IMF
single period model
2012 Thematic peer review Availability of IMF multi period
model, requires training
US CCAR & DFAST stress tests
2013 Start of phase-in of Basel III
capital standards
Revised liquidity standards
US CCAR & DFAST Stress Tests
Evolution of Stress Testing (continued)
Date Banking Regulation Changes Stress Testing (advanced) Stress Testing (emerging)
2014 EBA Stress Tests Increased use of monte-carlo
simulation
Increasing awareness of
advanced techniques
US CCAR & CPAR Stress Tests Development of DSGE type
models
Implementation constrained by
lack of data and expertise
BoE Stress Tests Increasing focus on liquidity
solvency interaction
HKMA Stress Tests Incorporation of feedback effects
China Stress Tests Increased use of market price
based models
2015 Application of Basel III
framework
Development of network models
and other techniques to model
contagion and spill over effects
Continued rollout of single
period models
2016 Further development in all areas Further experimentation with
multi period models
Still focus on solvency testing
and early stage liquidity testing
2016 New Standards for IRRBB Steadily growing interest
2016 Min Capital requirements for
Market Risk
Enhancement of models in line
with regulatory developments
Continued rollout of simple
excel models
Types of Stress Tests explained …
• Single period / multi period
• Single variable / multi variable
• Top down / Bottom up etc
• Portfolio / Sector / Bank / Non Bank / System level
• Accounting based / Market Price based
• Direct / Indirect assumptions
• Solvency / Liquidity / Liquidity solvency integrated
• Integrated / non integrated
• Macro prudential / micro prudential
• Internal / external
• Ad hoc / regular
11
Objectives of this course
To learn how to set up and run a straightforward single period stress testing process• How to design the tests• How to set up the model• How to stream line the model updating process• How to run checks on the data• How to analyze the banks as part of the set up process• How to set up assumptions• How to run credit, interest rate, FX, Liquidity, and contagion related
sensitivity tests• How to combine these tests into a single scenario• How to run reverse stress tests• How to analysis the results• How to report on the results• How to view bank level and system level results• How to adapt the model to suit your own requirements
12
A stylized stress testing process (9 stages)
13
Doted lines reflect feedback which can generate new iterations. Although here pivoting around the start date analysis they can start at any stage and refer back to any stage
Apply Shocks
Start Date Data
Historical Data
Start Date Data
Historical DataStudy
Measure
Shock
Shocked Output
Re-Study
Re-Measure
11 22 33 44 55 66 77
PerimeterMetrics, Type, etc
Risk, Macro economic, Financial
etc
GatherDesign
Scenarios
Create
88 99
Define
Purpose
ActConclude
Single Period Model (Sensitivities & Scenarios)
14
Data Assumptions
Credit RiskInterest
Rate RiskFX Risk
Liquidity Risk
Scenarios
Cihak ModelCihak Model
Reverse Stress Tests
Bottom Up
Interbank
Multi Period Model (Sensitivities & Scenarios)
15
Historical Data
Market Prices(eg FX rates,
equities)
Risk Factors(eg NPLs, PDs, LGDs)
Finance Factors(eg NII, Expenses, Assets, Liabilities)
Heuristics/benchmarkeing
Expert Opinion
Validation
Multi Entity / Multi Period Risk & Financial ModelCovers stress Horizon eg 3 to 5 years
Can incorporate liquidity impacts
Satellite ModelsInput generators Macro economic factors Risk Factors Growth factors Profitability factors Concentration factors CorrelationsMarket Price Based Models
Period on Period Balance Sheet
Period on Period P&L
Base date data
Historical data
Parameters and core assumptions
Period on Period ScenarioP&L and Balance sheet
Assumptions not included in satellite model outputs
Shock assumptions
Period on Period Off-Balance Sheet
Base date data
OutputIterations
Iterations
Market price modelling
Macro Economic Factors
(eg GDP, CPI)
Market Prices(eg FX rates,
equities)
Current Data
Output
Vulnerabilities
Losses by risk type
Thresholds & Metrics
RWA and CAR
Liquidity Outcomes
Recapitalisation needs
Liquidity and spillover implications
Output
Alternative Non Integrated
Version
A B
Basedate analysis
Challenger Models
EXAMPLE ARCHITECTURE OF A MULTI-VARIABLE / MULTI -PERIOD STRESS TESTING MODEL
EXAMPLE ARCHITECTURE OF A MULTI-VARIABLE / MULTI -PERIOD STRESS TESTING MODEL
Iterations
Questions and discussion …
16
Appendices
17
A look at Basel 2009 Stress Testing Principles for Banks
• P1: Stress testing to form an integral part of overall governance & risk mgmt
• P2: Should promote risk identification and control
• P3: Should take into account a range of views, perspectives and techniques
• P4: Should have policies and procedures
• P5: Should have suitably robust infrastructure
• P6: Should regularly maintain and update framework, assess effectiveness
• P7: should cover a range of risks and business areas
• P8: Should cover a range of scenarios
• P9: Should feature a range of severities
• P10: Should take into account numerous pressures in markets
• P11: Should be systematically challenged
• P12: Should cover complex and bespoke products
• P13: Should cover pipeline and warehousing risks
• P14: Should capture effect of reputation risk, eg off balance sheet exposures
• P15:Should enhance approach for assessing wrong way risk
18
A look at the Basel 2009 Stress Testing Principles for Supervisors
• P16: Should make regular and comprehensive assessments
• P17 Should require corrective action if material deficiencies identified
• P18: Should assess/challenge scope and severity of scenarios
• P19: Should examine results for capital and liquidity adequacy
• P20: should consider common scenarios
• P21:Should engage in constructive dialogue, have capacity and skills
19
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