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Stress testing and scenario analysis in

risk management
By
David Brawn and Alan Cathcart
Risk Review Department
Financial Services Authority

Presentation to
PRMIA Seminar
25 October 2006
Outline of talk
A. Introduction
B. Stress testing and risk management
C. Stress testing and regulation
D. Stress testing under Pillar 2
E. Thematic Review
F. Conclusions
A. Introduction
• Industry perspective
• Regulatory perspective
• Role of senior management
• What do we mean by stress testing
and scenario analysis?
What is stress testing?
• Two varieties
– Sensitivity analysis (or single-factor
tests) - identifying how portfolios respond
to shifts in relevant economic variables or
risk parameters;
– Scenarios - assessing the resilience of
financial institutions and the financial
system to severe but plausible scenarios
B. Stress testing and risk management
• What is covered by “risk management”?
– Day to day risk management
– Business planning
– Capital planning
– Strategy-setting
• Programme of stress testing
– Firm- or group-wide scenarios
– Range of more static stress tests
– Business unit stress testing
– Market risk or credit risk stress tests
– Ad hoc stress tests
How does stress testing help?
• Complements other risk management techniques
– “Sanity check”
– Reduced reliance on model parameters e.g. historical
correlations
– Can flex assumptions about business environment e.g.
market liquidity, ability to raise capital, competitive position
• Broad perspective
– Portfolio or business wide perspective
– Multiple horizons - sometimes instantaneous, sometimes
years ahead
• Transparency
– Management action visible
– Intuitive, easy to understand
Stress testing more than just a tool
• Stress testing assists senior
management:
– Assessing their view of risks
– Identifying risk concentrations
– Focussing on severe but plausible events
– Taking or planning mitigating action
C. Stress testing and regulation
• Regulatory attitude to stress testing
– Strongly in favour
– Emphasis on role of stress testing in
management of business
– Stress testing being written into regulatory
rules
• But
– Very little prescription from regulators
Why should this be?
• Financial regulation is forward-looking
– Focuses on adequacy of financial resources:
capital, liquidity, etc.
– Events which threaten objectives of consumer
protection and market confidence
• Inability of regulators to monitor firms’
exposures in detail
• Reliance on senior management of firms
• Stress testing needs to be proportionate and
adapted to the firm in question
FSA stress testing requirements
• FSA’s stress testing requirements derive
from our Principles for Businesses
Principle 3
“a firm must take reasonable care to organise and control
its affairs responsibly and effectively, with adequate
risk management systems”
Principle 4
“a firm must maintain adequate financial resources”

• Stress testing requirements also come from


Basel, the CAD and the CRD
FSA stress testing requirements
• Market risk (Basel market risk
amendment and CAD)
• Credit risk (Basel 2 and the CRD)
• Pillar 2 and GENPRU
• Liquidity
Pillar 1 Market Risk
• Why?

• Qualitative or Quantitative?

• Stress Test Design

• Prescriptive or not?
Why a Pillar 1 requirement?
• Only for VaR based capital

• Regulatory VaR
– Short Horizon/Liquid Markets
– Extreme tail of distribution
– Completeness
– Regulatory “Tinkering”
Horizon/Liquidity Issues
• Implicit in parametric models

• Historic Simulation “memory”

• How exposed are you to changes?

• Liquidity Adjusted VaR is complex


VaR is a measure of risk in the tail
• In large portfolios correlation is
dominant

• Have we correctly parameterised?

• Do we have sufficient data in His Sim?


Absent Risk Factors
• Insufficient Data

• Computational tractability

• Scenarios/Stresses used to generate


capital requirement
Regulatory Tinkering
• Two adjustments from VaR to capital
– 60 day averaging
– Multiplication by 3

• What is the final outcome?


Qualitative or Quantitative?
• Qualitative
– Supplementary management information
– Challenge to VaR
– Good measure of risk polarisation

• Quantitative
– Risks not captured in VaR
Stress Test Design
• The hardest question!
– “Severe but plausible”
– Historical versus prospective scenario
– Bottom up (“What’s the worst thing….”)
• Who’s responsibility?
– Senior Management involvement is
critical.
Prescriptive or not?
• At this point the answer should be
obvious!
• Effective stress testing should be:
– Position Sensitive
– Market Condition Sensitive
– Business Development Sensitive
FSA and stress testing
• In 2005, two industry workshops, a
Discussion Paper and a Feedback
statement
– FSA Discussion Paper 05/2 “Stress
Testing”, May 2005
– FSA Feedback Statement 05/02 “Stress
Testing: Feedback on DP05/2”,
December 2005
Comprehensive Approach
• In DP 05/2
– Six characteristics for an effective stress testing
programme
– Developed with the industry, not FSA guidance
• FS 05/2
– “we shall expect to see all firms, particularly the
larger and more complex institutions move
towards incorporating the principles of the
Comprehensive Approach within their risk
management systems”
Comprehensive approach (cont’d)
1. Senior management will be 4. Senior management will have
able to identify and articulate a an overview of firm-wide risks
firm's risk appetite and and stresses and a concept of
understand the implications of total risk even where precise
stress events within this aggregation is not possible.
context.
5. Senior management will
2. Senior management will take consider formally the
an active part in identifying implications of stress testing for
potential stress scenarios. a firm's strategy or business
profile.
3. Outputs from stress testing will
be communicated to senior 6. IT systems, resources and
management in procedures will allow senior
comprehensible format. management to identify,
quantify and manage efficiently
the stresses that affect a group.
D. Stress testing under Pillar 2
Capital planning and stress testing

Objective:
• That the firm can meet its capital requirements at all times
through out a reasonably severe economic recession.

Why capital planning?


• Not only interested in adequacy of capital today
• Want to be sure that firms will hold sufficient capital in the
future

Two aspects:
• Capital planning; and
• Stress testing.
Stress tests should be all
encompassing
• Stress tests should be all encompassing and primarily cover:
– Credit risk
– Market risk
– Operational risk
• It will be also important for firm’s to consider second-order
impacts:
– Changes to portfolio concentration levels
– Reputation (to the extent that the stress event is ‘name specific’)
– Impact on availability of liquidity sources
Capital planning and stress testing

Base case (how do management expect the business


£
to develop)

Capital

Capital generated as
business grows

CRR

Additional capital needed


as the business grows
time

Yr 1 Yr 2 Yr 3 Yr 4 Yr 5
Capital planning and stress testing

In severe stressed case (pre management actions)


£

CRR
•Firm makes losses
Capital
deficit

Capital

time

Yr 1 Yr 2 Yr 3 Yr 4 Yr 5
Capital planning and stress testing

£ In severe stressed case (post management actions)

•Raised extra capital


•Cut dividends (eg share issue) Capital (post)
•Reduced costs

CRR

•Reduced business volumes

Capital (pre)

time

Yr 1 Yr 2 Yr 3 Yr 4 Yr 5
Capital planning and stress testing

• Capital for future needs


• Projected CRR under stressed scenario
• Plus;
– Losses;
– Dividends
– Other appropriations

• Minus
– Profits;
– New capital raised (eg share issue)
– Other management actions (eg cut costs)
Capital planning and stress testing

• Challenges
• Realistic base case
• An appropriately severe stress test
• Credible management actions
E. Thematic Review
Thematic Review in 2006
• Sample of ten large financial firms in the banking,
building society and investment firm sectors. Visited
firms in Q2 and Q3.

• Objectives:
– Review of good practice
– Assessment against the characteristics of the
Comprehensive Approach

• Dear CEO letter sent to chief executives on 9th October,


published on FSA website on 16th October. Link:
http://www.fsa.gov.uk/pubs/ceo/stress_testing.pdf
Thematic review - results
• We saw a range of activity, with
developments and improvements under way,
but scope for further progress
• Some issues
– Senior management engagement
– Severity of stress events
– Effectiveness of presentation and communication
– Challenge or confirming business assumptions
Key findings
• Close engagement by senior • Communicating results clearly
management resulted in the and accessibly was important
most effective stress testing for many firms
practices.
• Good practice entailed using
• Good practice was observed group-wide stress testing and
where firms conducted firm- scenario analysis to challenge
wide stress tests of scenarios business planning
which were plausible, yet assumptions
under which profitability was
seriously challenged, key
business planning
assumptions were flexed or
scope for mitigating action was
constrained.
F. Conclusions
• Stress testing valued by industry and
regulators alike
• Scope for progress within firms
• Pillar 1 and Pillar 2 requirements are
challenging
• Dear CEO letter was published in October
2006
• Continued focus on stress testing by FSA
• Stress testing can help reduce risk in the
financial system

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