Increasing interaction and integration of liquidity and capital stress tests for a unified view of impacts

By Martin Marchesi, Head of Stress Testing & Credit Projection, Intesa Sanpaolo

What, for you, are the benefits of attending a conference like the ‘Stress Testing Europe Summit’ and what have attendees learnt from your session?

Stress Testing has been a topical matter for banks in the past years and it is not difficult to foresee a further increase in its importance for the coming years. As witnessed by the development of the reference documentation on the topic, there is in general still room for improvement for banks, for instance in terms of risk coverage, integration within managerial decision making and strategic planning, scenario design and integration among risks, just to mention a few.

Depending on the context and on the objective, banks may find themselves running Stress Tests in a very standardised way or, on the opposite, using tailored models or approaches; either way, in such a rapidly evolving environment, an interaction and comparison with peers is undoubtedly an opportunity.

In my session I tackled the topic of the integration of capital and liquidity Stress Test, one of the goals banks have to achieve to move towards a deep and full understanding of the effects that a stress may have on a bank.

How can risk professionals best understand the link between liquidity and capital?

Often Stress Tests are run in a sort of test tube approach, where capital and liquidity are considered two different silos with no interaction. In real life, however, the interaction between the two is extremely strong: just to make a couple of straightforward examples, think of the impact that a liquidity shock may have on capital through the increase in cost of funding and, on the other hand, the funding outflow which could follow a significant event having impact on capital. Nowadays, especially in more complex institution, risk experts tend to be specialised on a specific risk, while understanding the full range of impacts a specific scenario/event may have on a bank requires cross competences, in some circumstances close to those of a planning and control expert. Combining the expertise of different risk experts and introducing a coordination role of specialised teams with cross competences is one of the answers; the full understanding of the interaction of different risk has to be understood well before running the exercise, when risks and risk factors are identified and the combined scenario has to be depicted.

Why is it important for risk professionals to gain an integrated view of risk?

If only run for regulatory purposes, Stress Tests become a pure cost to be bore by banks. Benefits from such exercises increase when results are representative of banks’ specificities and are close to what would happen in real life. An integrated view of risk would provide additional insight also outside Stress Testing, for example in the process of limit setting as well as in the ex-ante evaluation of risks emerging from new businesses.

What are the challenges of calibrating liquidity and capital stress tests?

The integration of capital and liquidity Stress Testing stems from an integrated scenario: traditional banking business usually envisage a good reactivity of capital to pure macroeconomic effects while, to observe significant effects on liquidity in a reasonable time, also idiosyncratic elements should be included. This poses also some challenges when the selection of a scenario is based (also) on a desired level of severity. An effective calibration also need a good ex-ante knowledge of second round effects, especially in the case of a reverse Stress Test.

In your opinion, what does the future hold for the integration of liquidity and capital stress tests?

In my view Stress Test framework is doomed to move towards an evolution which should shift their Stress Testing from a theoretical exercise towards a more realistic but sophisticated analysis of the effects of stress scenario/events; in a risk management perspective, second round effects cannot be neglected and the analysis of potential remedial actions and of their feasibility has to be carried out taking into account all the potential vulnerabilities which may emerge in the given scenario.