Using stress testing alongside risk appetite for more informed decisions

Using stress testing alongside risk appetite for more informed decisions

Tally Ferguson
Tally, can you please tell the Risk Insights’ readers about yourself and your professional experience?
I have been in the financial industry for over 30 years, almost always in a “second line” role.  I started as an International Bank Examiner with the Federal Reserve Bank of New York.  There I saw Bankers Trust give birth to RAROC and JP Morgan give birth to RiskMetrics.  The swaps market was five years old when I started.  When I left after a decade, derivatives had not yet evolved to financial weapons of mass destruction, although I got to witness some impressive income waxes and wanes from derivative transactions.
After the Fed, I served two years as a regulatory consultant for Ernst & Young and helped clients implement numerous regulatory initiatives including comprehensive risk management programs and interest rate risk initiatives.  There, one of my clients was the Bank of Oklahoma (“BOk”).  In 1996, BOk had need of my capital markets and regulatory skills.  I had family in Oklahoma, so I joined BOk.  There, over the past 20 years, I served multiple 2nd line of defense roles, almost always connected to capital markets, market risk, and model risk management.  Currently I am the Director of Market Risk Management at BOk, responsible for enterprise wide market risk monitoring, model risk analysis and validation and coordinating the corporate insurance program.
You presented at the Stress Testing USA: CCAR & DFAST Congress where you delivered a presentation on stress testing alongside risk appetite for more informed decisions. Why do you feel this is a key talking point at the Congress?
Nearly a decade as a regulator, burned an as yet indelible psyche in my brain that there is value to be gleaned from regulations. Admittedly, finding value from the Dodd Frank Act is a challenge. The requirements for Volcker, Swaps rules and, of course, Section 165 (includes stress tests) are, to be blunt, onerous.  Of these, stress testing is the most pervasive.  Every bank with over $10 billion in assets had to address stress testing in some fashion.  Specifically, the industry built up quant departments, created modeling teams, and created feeds from myriad source systems into one clearing house for projecting balances, income, expenses and capital. We also prepared thousands of pages of documentation most of which only the preparers will read.
This Herculean investment MUST be worth something beyond attaining “reliable” ratings from examiners and making them read through tomes of material to find the kernels of wisdom they seek.  I think my midsize bank peers share my quixotic belief, and I suspect the CCAR banks have already begun cashing in on their investments.  The question becomes, then, how do we cash in.  That brings me to your question.  At the conference, I proposed that tying our risk appetite to DFAST results is one way to cash in on our DFAST investment.  I imagine we are all looking for such ideas, making this a timely topic for the Congress.
Do stress test results lend themselves to risk appetite tolerances?
A superficial response to your question is “sure, regulators restrict capital planning if results fail to meet their expectations.”  We set tolerances in our risk appetites for most activities that could impair our ability to manage or maintain capital, so why not set them for DFAST.  The problem is, what threshold do we set?  “Pass DFAST” is neither interesting nor helpful as a tolerance.
If we consider your question in more depth, though, we get an interesting answer.  Let me stimulate discussion with two risk tolerance examples.  I summarize these in table 1 below.
Table 1
Example Pros Challenges
1.   Minimum capital ratio or threshold Easily measured, understood and readily auditable Could force managing to Armageddon

Arbitrary scenarios that change each year

2.   Maximum change in capital Ratio Highlights to which scenarios capital is most sensitive

Requires management to analyze components of capital contribution and confirm the returns they generate is worth the risk.

Difficult to define a prescribed response to exceeding tolerance

 

To begin, reflect on what DFAST tell us.  It shows our capital levels over 9 quarters under three different economic scenarios that we may or may not consider plausible.
For risk tolerance example 1, let’s set minimum capital ratios or levels for each scenario and quarter.  We can easily measure such a threshold, and anyone can tell whether we are within our outside our tolerance.  For example, the threshold could be a total capital ratio of 10% in severe stress.  If the severe stress case shows a capital ratio below 10% in any of the 9 quarters, the threshold is tripped and action must be taken.
But is that useful? What action do we take when a scenario takes us below our tolerance level? The correct response might be to raise more capital.  If so, setting an appetite in this way is appropriate.  That said, the scenario that trips the tolerance might be excessively severe and remote.  Further, the bank might start with a large capital cushion over regulatory minimums.  In that case, raising capital is not the most appropriate response. It would hurt shareholders, ironically incent more risk taking and exacerbate executive compensation.  This is tantamount to managing to Armageddon.  Banks that manage to Armageddon have difficulty remaining competitive.
With example 2, let’s focus on sensitivity rather than projected absolute capital ratios or balances.  Here, we set a tolerance on how much we let capital ratios change from base to stress conditions.  For example, the threshold could be that the total capital ratio may not fall by more than 250 basis points from the base to the severe stress scenario.  The risk appetite could require analysis and recommendations if the 250 basis point threshold is tripped.
Is this approach useful? I think so because it gives management more insight into how its business lines impact capital.  Perhaps there is one business line, say subterranean toxic waste lending in the Gulf, that consumes 200 of the 250 basis point drop.  Management knows to look critically at the returns from that business.  Conceivably, with a name like subterranean toxic waste lending in the Gulf, management wouldn’t need a DFAST related appetite tolerance to look at it critically.  What about a more innocuous sounding business line like, Credit Default Desk, or Subprime mortgage securitization?  The severe stress case in the 2016 DFAST scenarios would have shown both to take a considerable chunk out of total capital ratios.

What are the benefits of using stress testing results to inform the risk appetite?

By design, stress testing requires management to look at plausible worst case scenarios. Risk Appetites are normally conceived in a Business As Usual (“BAU”) circle. I recognize that setting tolerances consistent with risk appetites involves thinking about tail events. Nevertheless, few set risk appetite tolerances based on being in a prolonged stress environment. Indeed, we should not do so because the gulf between that and managing to Armageddon is not that great. So a stress test lets us look at our performance from a dystopian viewpoint. From that viewpoint, we know where we will need to portage and where we can keep on paddling. A risk appetite that allows more paddling than portaging in stress environments is more robust and will better serve a bank. A risk appetite that lets you paddle only until the next nasty turn is less useful. As I’ll elaborate at the Congress in November, stress testing, which we have to do anyway, is an effective way to tell those two risk appetites apart.
I love this question, but I was not permitted to answer it beyond what we disclose in our DFAST public disclosure, and that limitation makes my response decidedly uninteresting.

 

How do you see the industry progressing over the coming years, in light of recent changes and trends?

I believe in rate increases so much that folk have caught me clapping in my cubicle – don’t judge me, it worked for Tinkerbell! For those unfortunate enough not to get my allusion to Pantomime Theatre, let’s assume we continue in a low interest rate, innovation challenged, compliance burdened industry. Worse still, unregulated financial services companies and robots challenge us with increasingly competitive product offerings from payment channels to financial advice. That leaves us with lower margins and fewer customers. How can we grow?

I guess we could look on the bright side. The next dozen years will see the largest transfer of wealth from one generation to the next in the history of humans, and people still trust banks more than car dealers. Technology enables integration in ways unimaginable even 10 years ago. If we can’t beat the unregulated financial services companies and robots, maybe we can join them, joint venture with them or assimilate them.

In either event, the pickings will be slim, margins tight and regulatory standards high. A financial institution that can leverage regulatory standards can outperform one that does not, and tying stress test to risk appetite might just be one way to make that happen.

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