An article by BCS Consulting, Chris Cardwell, Managing Director, Erkin Nosinov, Director, Faye Raw, Managing Consultant and Charles Hildebrandt, Managing Consultant.
Enterprise stress testing and scenario analysis, the process whereby banks assess their financial resilience to macro-economic or market-driven scenarios, has changed almost beyond recognition in the last decade. What used to be a simple, top-down process has become a complex bottom-up modelling exercise, involving almost every function within the bank and the storm’s not going to abate.
Recent changes in enterprise stress testing methods have been driven largely by the un-forecasted events of the financial crisis and the subsequent regulatory response to those events. Many banks have struggled to adequately respond to frameworks such as CCAR and STDF 1 and have been forced to rely on short-term, tactical solutions. A wide range of different operating models have emerged, as the sector responds to the rapidly changing regulatory landscape.
Substantial investments have already been made. However, rather than a period of tranquility, we believe the pace of change will continue for at least another five years. The methods and infrastructure used in the next decade will fundamentally differ to those currently in place. Whilst the regulatory agenda will continue to be a major catalyst, we believe that three principles will underpin enterprise stress testing and scenario analysis operating models in the future:
- Stress testing and scenario analysis will become a ‘first line’ activity, ceasing to be something done to the business by Risk and Finance. Banks which incubated capabilities within their second lines of defence will undergo a period of transition as processes and capabilities are transferred into risk-taking functions.
- Models and methodologies will become more integrated and product-centric. They will focus on portfolio dynamics and the interplay between volume, margin and risk. Models which evaluate risk and revenue items in isolation will be phased out.
- Consistent enterprise scenario analysis methods will underpin a broader set of activities, ranging from strategic planning to regulatory stress testing and recovery planning.
Operating models, risk methodologies and investment priorities currently vary considerably across the industry. This is likely to continue over the short-term as banks build on what they currently have, in order to meet immediate regulatory demand. However, over a 5-10 year timeframe, the industry will move towards consistent adoption of a standard operating model characterised by the three principles outlined above.
Transitioning to the first line of defence
Regulatory attitudes have driven recent investment in enterprise stress testing and scenario analysis. The majority of banks met regulatory demand by boosting capacity in their Risk teams, leveraging skills already present within their second line of defence. This approach has allowed the industry to quickly improve its ability to meet compliance objectives, it is also one of the reasons why banks are deriving limited value from the process.
Enterprise stress testing is an exercise in risk articulation but it is not a simple risk measurement activity. Due to the complexity of the analysis and the extreme nature of the scenarios, it will always retain a highly subjective element. Any insights which can be gained from a stress test typically come not from the final output but from participation in the process itself. If Risk and Finance are accountable for all forms of enterprise scenario analysis while risk taking functions have limited involvement, the process can become viewed as a simple compliance issue. If this happens, banks run the risk of failing to extract any real value from the investment they are required to make.
Over time the industry will therefore migrate towards the following division of accountabilities:
- Scenario projections and the interpretation of results will be managed within the first line of defence, supported either by Operations or captive Risk and Finance teams.
- Risk, as the second line, will be accountable for the overall scenario analysis framework and governance over policies and models. They will also perform independent review and challenge.
These operating model changes will be driven by two factors. Firstly, banks will seek to gain additional value from the investment required to ensure regulatory compliance. To achieve this they will have to involve a broader range of risk-takers in the analysis. Secondly, regulators will increasingly insist on business ownership of stress testing outside of the CRO and CFO functions. This expectation is already present for executive level management and is likely to be required further down the ranks in the near future.
Recent information emerging about the PRA Biennial Exploratory Scenario for 2017 reinforces this driver. Rather than a short sharp shock and recovery, the scenario is likely to focus on long- term changes in the business environment and mitigating actions to adapt the business model and maintain profitability – the domain of front-office and strategic planning.