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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”
• Qualitative or Quantitative?
• 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
• Computational tractability
• 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.
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
Capital
Capital generated as
business grows
CRR
Yr 1 Yr 2 Yr 3 Yr 4 Yr 5
Capital planning and stress testing
CRR
•Firm makes losses
Capital
deficit
Capital
time
Yr 1 Yr 2 Yr 3 Yr 4 Yr 5
Capital planning and stress testing
CRR
Capital (pre)
time
Yr 1 Yr 2 Yr 3 Yr 4 Yr 5
Capital planning and stress testing
• 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