Reviewing evolving Stress Testing processes: BAU, data and the practicalities of running a stress test

Reviewing evolving Stress Testing processes: BAU, data and the practicalities of running a stress test

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.

Additionally, stress testing has been receiving increasing interest over the last few years, both within banks and externally by the regulators. Inevitably this growth in interest has resulted in more questions and therefore an inexorable increase in the quantity of data involved in the stress testing process. This poses increasing challenges as to the way banks approach stress testing and the challenge of having something more automated with increased controls around it, reducing the ability to be flexible. Therefore, as a whole there is far more data to grapple with in stress testing in comparison to what there was even a couple of years ago, and data continues to be an ever-growing challenge for stress testing experts.

A final area of discussion is around the practicality of actually running a stress test, particularly running one from its beginning to end point and the process banks go through. For example, how do banks turn a stress testing scenario into a viable scenario that can be easily understood for example? Stress testing scenarios that are produced by supervisors are designed for all banks taking part in the stress tests, but each bank has a unique structure to it. It can therefore be harder for one bank to turn a stress test scenario into a viable scenario in comparison to another bank. Furthermore, it can be challenging to craft a scenario into something that can actually be modelled. It is all well regulators’ giving banks a scenario to test their resilience to, but actually modelling this to see how the scenario would play out is more complex. Banks then have the challenge of actually deciphering whether there are credible management actions that can be taken to lessen the impact of that particular scenario occurring. Whilst stress testing in theory works really well, in practice it is almost evolving into an art as much as a science.

Overall there is much for the industry still to ponder as it looks towards the results for this year’s EBA and Bank of England Stress Tests, which are expected to be published in early Q3 and Q4 respectively. As stress testing processes and requirements evolve there are still many challenges outside the ones discussed in this piece that need addressing. Network and discuss these challenges at the Center for Financial Professionals’ Stress Testing Europe Summit, where senior regulators and stress testing professionals will come together to review evolving stress testing processes and requirements and look towards the next phase of development.

 Visit: www.stress-testing-europe.com for further information and to view the agenda across the two-day summit. For further information, please get in touch with a member of the team on +44 (0) 207 164 6582.