Since the financial crisis stress testing has been increasingly used, most prominently in the US, but also in the last few years in the UK and Europe, as a key tool in examining the vulnerabilities in banks balance sheets and their ability to withstand adverse economic scenarios or shocks. The theory around the purpose of stress tests is simple enough, as they allow supervisors to assess banks resilience to ensure whether or not they are sufficiently capitalised to withstand such adverse scenarios, in the event that one does actually occur somewhere down the line. However, in practice running stress tests is not so simple.
Due to the ever-increasing stress testing regulatory demands, The Center for Financial Professionals conducted extensive research to assess the main stress testing challenges that financial institutions are facing. This piece will explore three of the most prominent areas that came up during the research; embedding stress testing into a ‘Business as Usual’ (BAU) framework for more effective risk management, the ever-constant stress testing data challenges and the practicalities of actually running a stress test.
Many during the research highlighted the significance of embedding stress testing into a BAU framework to ensure more effective risk management across the organisation. The importance of stress testing is not lost on financial institutions, with the Bank of England and EBA conducting regular stress testing exercises in order to determine how individual banks can withstand given economic scenarios, being pushed to the limit of their resources. However, it is important for banks to use stress testing for internal risk management within the organisation and not just as a regulatory tool. Banks spend a lot of money on infrastructure and labour to support their relevant stress testing, and it seems a waste of valuable investment to utilise it by just ticking a regulatory box. Banks should be deriving value from their investment by improving their risk management capabilities and then using their risk management capabilities to manage their business and improve the risk management of their organisation. One of the reasons that regulators have stress testing exercises is that they are not confident that banks are using them internally, and therefore are not in control of their business. Therefore if banks can use the tools internally to help optimize their business, then satisfying the regulators demands should become more straightforward. In other words, in an ideal scenario banks should be constantly coming up with their own internal economic scenarios to stress throughout the year, so that when it does come to regulatory stress tests it is information that banks already have.
Another area of focus, one that will inevitably always come up as a key area throughout risk management is the data challenges involved in stress testing and ensuring that data is used as a tool for effective stress testing. A prominent challenge that banks were in unanimous agreement on was the linkage between risk and finance, a relatively new concept where banks are looking across finance and risk data within stress testing. Within organisations there is still a lot of separation between risk and finance data, so the challenge is bringing the two together and trying to ensure some form of consistency. Risk professionals agreed that overall the interaction between risk and finance is a pivotal part of stress testing.