stress testing - a driver for the integration of risk management ......embryonic process and tools,...

Stress testing - a driver for the integration of risk management and the business

April 2012

Dr. Christian Thun, Senior Director

Stress Testing April 2012

Topics for discussion

• Stress testing – How to approach it best

• Building a robust framework for Stress Testing

• Utilising the results for business planning and decision making

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Stress testing – How to approach it best

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Stress Testing: Lessons learnt

Definition :

A stress test is commonly described as the evaluation of the financial position of a bank under a severe but plausible scenario to assist in decision making within the bank

The financial crisis has highlighted weaknesses in current stress testing practices.

» Use of stress testing and integration in risk governance

» Stress testing methodologies

» Scenario selection

» Stress testing of specific risks and products

Source: BIS, Principles for sound stress testing practices and supervision, 2009


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Maturity levels varies according to regulatory requirements and bank overall risk management sophistication

Laggards

Followers

Practitioners

Leaders » Leaders in practice » Comprehensive process

and governance » Dedicated resources » Models and systems » Input into the business

strategy and part of ERM » All risks are stressed

» Leaning towards business usage

» Comprehensive process and governance

» Mostly quantitative analysis

» Dedicated resources » All risks are stressed

» Responding to regulation » Process in place » Some quantitative analysis » Regulation driven » Several risks stressed

(credit, market risk)

» Early stage » Lack of process » Expert judgment » No dedicated resources » Only market risk

stressed

Input into

business strategy

Sophistication

8 Banks interviewed 14 Banks interviewed 13 Banks interviewed 6 Banks interviewed

Reg

ulat

ion

driv

en

Bus

ines

s dr

iven

Methodologies governance, tools and dedicated resources Embryonic process and tools, no dedicated resources

Illustration of market maturity levels


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Stress testing requires a unique combination of data, domain expertise, and technology

Define Scenarios Data and Infrastructure

Model the impact of scenarios on key risk

parameters

Calculate Stressed KPI

Reporting Management actions

3 4 5 7 Define scope

and governance

1 2 6

1 Sources of Liquidity Risk (FSA): Wholesale secured and unsecured funding risk, Retail funding risk, Intra-day liquidity risk, Intra-group liquidity risk, Cross-currency liquidity risk, Off-balance sheet liquidity risk, Franchise viability risk, Marketable assets risk, Non-marketable assets risk, and Funding concentration risk 2 Sources of risk from ALM perspective: client’s behavior, funding risk, facility utilization, prepayments, runoff

• Shock selection: • Regulatory • Business-specific:

macro/ budgeting/ planning; financial markets, liquidity.

• Test selection: • Sensitivity analysis • Scenario analysis • Reverse ST • Validation of

parameters

Des

crip

tion

of A

ctiv

ities

• Scope and governance rules of ST programme

Out

put

• Define data and granularity requirements

• Define infrastructure requirements

• Source data • Compile and format • Audit quality

• Enter stressed inputs into software and run calculations to obtain:

Capital • Regulatory capital ratio (total RWA, RWA ratio)

• Stressed net income • Economic capital ratio • Eligible capital ratio • Leverage ratio Liquidity (cash-flows) • Liquidity gap, cash-flows and liquidity ratios

Market • Stressed VAR • Aggregate and validate

results

Credit risk • Model impact of

scenarios on probabilities of default

• Model impact of scenarios on losses

Liquidity risk • Model impact of

scenarios on short term and long term cash flows

Market risk • Model impact of

scenarios on trading books

• Consolidate results • Format and audit • Internal reporting to

management • Periodic reporting to

Board, ALCO, and other Committees

• Public disclosures to local regulator

• ICAAP & ILAA reports

• Compare with risk appetite guidelines

• Revise credit limits, liquidity planning and asset growth limits and contingency plan

• Scenarios (regulator’s and/or idiosyncratic)

• Stressed PD, EAD, LGD • Stressed cash-flows • Stressed financials (loan

loss provisions, interest income, refinancing costs..)

• Stressed EcCap / RegCap/BookCap

• Liquidity gap and ratios

• Stressed P&L • Stressed VaR

• Risk appetite and limit management process

• Reporting and disclosed information (internally and externally)

• Define scope: • Regulatory • Business-specific • Define risk factors :

credit, liquidity1, market risk, ALM2, operational..

• Governance (ownership, review, frequency, reporting)

• Data input into models and/or platforms

Source:: market research and own elaboration

Moody’s Analytics identified a 7- step process for stress testing


Building a robust framework for Stress Testing

7

2


Stress Testing Framework

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Stre

ss te

stin

g in

frast

ruct

ure S

tress testing governance

Management action

Stress test output

Stress testing methodology

Sensitivity analysis

Scenario analysis

Reverse Stress test

Severity

Scenario

Regulatory requirements

Source: Financial Service Authority


Three Basic Steps Connecting Macroeconomic Indicators to Conditional Loss Distribution

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A. Link a set of Macro Factors (say: GDP, Unemployment etc.) to the time series of Factor Variance and Factor Returns underlying correlations

B. Calibrate the sensitivity of the factor time series to PD, LGD and RSQ using the empirical realizations

C. Apply a stress scenario to solve for new PD, LGD and Correlations; use these as inputs to estimate portfolio credit risk using a portfolio model

Macro- economic Indicators

Factor Returns & Variance

Risk Drivers- PD, LGD, RSQ

Portfolio Loss Distribution

A B C



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A B C


Global Economic Conditions (April 2012)

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Moody's Analytics closely tracks economic conditions in the major economies of the world and summarizes the results on this interactive map. Analysts follow a wide range of indicators to ascertain a country's position in the business cycle. Specifically, we focus on gauges of employment, industrial production and retail sales--high-frequency indicators that capture the breadth of economic activity. Countries where the indicators are dropping are labeled In Recession. Those where declines have slowed are said to be At Risk. Countries where the indicators have begun rising again are Recovering. Economies that have advanced past their previous growth peaks are labeled Expansion.


» On a monthly basis our economists produce the baseline forecast, which represents the estimate of the most likely path for the respective economy through the current business cycles (50% probability that economic conditions will be worse and 50% probability that economic conditions will be better)

» Standard economic scenarios are developed around the baseline forecast and are updated on a quarterly basis

Healthy Economy Weak Economy

Baseline “BL”

S2: “1-in-4”: 75% probability economy will perform better



S1 represents the best scenario and S4 is the worst

Client

Scenario: Double Dip S1:

Faster Recovery

Alternative Scenarios Key for Stress Testing

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Stressed dynamics of some macroeconomic variables


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Translating scenarios into changes in risk drivers A borrower’s probability of default is a function of the borrower’s Distance-to-Default (DD)

A stressed Distance-to-Default for each borrower can be determined by calculating an econometric relationship between changes in borrowers’ Distance-to-Default with factor returns and changes in factor variance.

Stressed Factor Variance and Stressed Factor Return stressed stressedk kDD PD⇒ ⇒

Total distance to default Asset Value

Today Time

Default probability (EDF = Empirical Default Frequency)

1 Year

Expected Market Value of Assets Asset volatility

(Standard Deviation of Assets)

Default Point

The “Distance to Default” is the distance between the Market Value of Assets and Default Point, expressed as a multiple of Asset Volatility:


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100

150

200

250

300

350

400

06/00 11/00 05/01 11/01 05/02 11/02 05/03 11/03 05/04 11/04 05/05

N-TROPICAL SPORTSWEAR INTL CP-AVL N-TROPICAL SPORTSWEAR INTL CP-DPT

Source: Credit Monitor

Market Value of Assets

Default Point (Liabilities Due)

Default Example: Tropical Sportswear Intl.

Defaulted December 2004

Default Point Market Value of Assets


What drives changes in asset value?

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Apple Inc.

Hewlett Packard

Dell Inc.



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A B C


Understanding stressed asset values

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• Moody’s Analytics uses a factor model to de-compose the asset returns of firms

• The factor model approach imposes a structure on the composition of asset returns, which implies that the correlation between the asset returns of any pair of firms can be explained by the firms’ relationships to a set of common factors

• A composite company specific factor (systematic risk)

• Country and industry factors

Changes in Asset Value

Borrower –specific Risk

Systematic Risk

Country Risk Factors

Industry Risk Factors

RSQ 1-RSQ


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Connecting Factor Returns and Macro Variables - for Two Industries in Germany

-0.4

-0.3

-0.2

-0.1

0

0.1

0.2

0.3

0.4

-2.5

-2

-1.5

-1

-0.5

0

0.5

1

1.5

2

2.5

Fact

or R

etur

ns

Mac

ro V

aria

bles

Time

Chg Unemployment Rate Chg Lending Rate Consumer Products Finance Companies



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A B C


EDF Measures in a Stress Scenario: 1-in-a-25 Year Recession

-

5.00

10.00

15.00

20.00

25.00

30.00

35.00

- 5.00 10.00 15.00 20.00 25.00 30.00 35.00

EDF 2009 Q1

EDF

Seve

re S

cena

rio

EDF 1 Year Severare Scenario Linear (EDF 1 Year) Linear (Severare Scenario)

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A B C


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Visualizing the Impact of Stress Conditions on a Portfolio

Probability

Portfolio Loss

Unconditional Loss

DistributionConditional

Loss Distribution

ELU ELC 99.xx%U 99.xx%C

Interesting ProbablyNot Interesting

Interesting questions:• What losses would be expected in a stress

scenario? (= ELC)• What is the unconditional probability that

losses would exceed ELC? (= shaded area under unconditional loss distribution)

• What is the probability that stress scenario losses would exceed unconditional required EC? (= shaded area under conditional loss distribution)

Interesting?


Utilising the results for business planning and decision making

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Stress testing is relevant to many functions in the bank

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Multiple areas of the banks are targeted, with particular focus on credit, liquidity risk and P&L

Overview of Stressed KPI

Source: market research and own analysis

Retail

Corporate

CRE/ SME

Credit risk Stressed Regulatory Capital ratio / Economic Capital ratio / Book Capital ratio

Liquidity risk

Liquidity risk parameters Basel III Liquidity ratios

Market risk Stressed VaR / Regulatory Capital ratio

Market risk parameters

Operational risk

Operational risk parameters Stressed Regulatory

Capital ratio

P&L/ Balance

Sheet

Factors affecting P&L/ Balance Sheet

Stressed Cash-flows/ Net Income/ Book Capital ratio

Many functions are involved in stress testing but there is usually no single ownership

Source: Market research (42 interviews conducted with a sample of 41 banks of all sizes across Europe) and own analysis

47%

12% 7%

9%

7%

5%

13%

Functions interviewed (% of respondents)

Group Risk Management Portfolio Management Credit risk Finance Risk Control Market risk Other


Questions to ask yourself

• Does my stress testing framework really represent a stressed environment?

• What are the key vulnerabilities of my business?

• Does my risk profile matches my risk appetite?

• Am I concentrated in areas that are exposed to excessive risk under stress?

• Can I hedge positions or reduce limits?

• Are my liquid assets also liquid under stress?

• What are sources of funding/capital in times of stress?

• Is my organisation / governance prepared for times of stress?

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stress testing - a driver for the integration of risk management ......embryonic process and tools,...

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