Volker Weis, Head of Group Stress Testing, Enterprise Risk Management, Deutsche Bank gives us an insight into the use of stress testing for setting risk appetite to inform strategic decision making.
I came into banking as a career changer moving from academia into a quantitative risk management function initially dealing with credit risk related topics (deal pricing). Over the course of the years I broadened my background by working on the Operational Risk AMA model and was later on responsible for the development of the risk engine to compute the counterparty credit risk arising from derivatives transactions under Basel 3. Using this x-risk view, I then resumed responsibility for ICAAP and the development of various Economic Capital models. In my current role as head of group stress test, I am looking after the X-risk group level stress where I can leverage the previously gathered experience across the various risk types.
Stress Testing to help define risk appetite
Using stress testing in the setting of risk appetite is one option out of several approaches only. The advantage of having stress test results entering the risk appetite allows the consideration of the ‘real’ risk profile and sensitivity of the organization under macroeconomic scenarios the organization considers as relevant.
Let’s think about pillar 1 capital requirements for instance. There are certain generic as well as bank specific components a bank must meet at all times, even under a stress situation. Knowing the sensitivities of the organization to a set of different plausible stress scenarios allows to define a series of risk appetite thresholds to which a clearly defined escalation process should be linked. Such an approach can be applied at consolidated group level but equally at lower organizational entities as well as to other important KPIs.
Stress testing to dictate the business model
The business model of an institution is determined during the strategic planning process which is typically an iterative process. Stress testing the various iterations of a strategic plan prior to finalization and benchmarking the outcome to the risk appetite framework provides valuable information how the business model performs under downturn conditions. In case of poor performance under stress, a rework of the business model and related strategic plan may be required.