Macro-Prudential Policy and Financial Stability:

Issues and Challenges16-18 December 2013

Intercontinental HotelAmman, Jordan

Stress Testing Banks and Financial Institutions

• Good practices• Stress testing models and scenarios• Practical considerations

Mr. Keith PooleyMETAC Banking Supervision Technical Expert

The importance of stress testing“Stress testing plays an important role in:

providing forward-looking assessments of risk;

overcoming limitations of models and historical data;

supporting internal and external communication;

feeding into capital and liquidity planning procedures;

informing the setting of a banks’ risk tolerance;

and facilitating the development of risk mitigation or contingency plans across a range of stressed conditions.”

Stress Testing and Risk Governance“Stress testing should form an integral part of the overall governance and risk management culture of the bank.

Stress testing should be actionable, with the results from stress testing analyses impacting decision making at the appropriate management level, including strategic business decisions of the board and senior management.

Board and senior management involvement in the stress testing programme is essential for its effective operation.”

Stress Testing and Capital Plans

“Supervisors should consider the results of sensitivity analyses and stress tests conducted by the institution and how these results relate to capital plans.” 3

GOOD PRACTICESWHAT DOES BASEL SAY ABOUT STRESS TESTING?

STRESS TESTING GOOD PRACTICES

The following slide provides an example of good practice in relation to the Governance Framework

The process is Board-led, with the Board: proposing some of the scenarios to be

run challenging approaches, scenarios and

outputs approving approaches, scenarios and

outputs receiving sufficient training to support

these objectives

GOOD PRACTICES - GOVERNANCE

Under leading practice, stress testing needs a set of governance arrangements driven primarily by the Board and an integrated operating framework.

Board and senior management engagement

Clear responsibilities, allocated resources, and written policies and procedures

Embedded into risk management processes and supported with an appropriate risk infrastructure

GOVERNANCE FRAMEWORK

Outputs are actionable and inform strategic

decision making

Governance of stress testing and use

Regular review of programme to assess its

effectiveness

GOOD PRACTICES – OPERATING FRAMEWORK

The following slide provides an example of good practice in relation to the accompanying Operating FrameworkThe framework encompasses: macroeconomic stress tests, scenario / ‘what-if’ analysis and sensitivity

analysis - appropriate for the scale and complexity of the asset classes

assumptions are sufficiently challenged and tested

Outputs inform: management actions and gross and net

impacts Pre-emptive responses to manage

vulnerabilities Strategy and capital/liquidity requirements

Firm strategy

OPERATING FRAMEWORK

Capital planning•Identifying capital required to support growth

• Link to ICAAP

Stress Testing

QuantitativeElements

(e.g. GDP, CPI)

Define scenarios

Identify consequence Assess impact (quantitative &

qualitative)

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GOOD PRACTICES – OPERATING FRAMEWORK

TYPES OF STRESS TESTS

TYPES OF STRESS TESTS

Exposure

Rating class

Sensitivity analysis

Defined by shift in sensitivity variable

Relatively easy to define and implement – often used at trading desk and business line level

Shifts in several variables have to be used in order to simulate historical events

Correct use of stressed correlations between risk types is essential

SENSITIVITY AND SCENARIO ANALYSIS APPLIED TO CREDIT RISK AND MARKET RISK

Sensitivity analysis Scenario analysis

Credit risk

Market risk(incl ALM)

What if all ratings worsen by one grade?What if default rates double in portfolios X,Y,Z?What if all correlations on our credit portfolio model increase by 20%?What is our collateral recovery rates are systematically 25% lower for real estate collateral?

What is the EUR/USD rate changes by X%?

Parallel shift of yield curve by X basis points?

Increased in implied volatility of European stocks of Y%

What if there was an emerging market crisis (contagion effects)?

GDP down 6-8%?

Deflationary vs. inflationary?

What if the previous historical boom and bubble in house prices leads to a long-lasting retail mortgage credit crisis?

What if exchanges rates or interest rates behave as they did historically during period X?

What if interbank liquidity dries up during next economic shock?

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THE CLASSIFICATION OF GLOBAL STRESS SCENARIOS

Global stress scenarios can be classified accordiing to the construction of the scenarios

Identification or relevant risk drivers and risk types. The corresponding elementary stress scenarios are then put together to yield a global scenario

Starting from a given multi-risk scenario, identified as being relevant to the risk profile, and the corresponding quantification in terms of single risk types

BOTTOM-UP

TOP-DOW

N

Moderate scenarios Challenging scenarios Extreme scenarios

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TOP DOWN APPROACH TO DEFINING STRESS SCENARIO

Senior management

Strategic planning department

Research department incl. chief economist

Competitive expectation

Macro-economic expectation

Risk controlling Moderation of scenario definition and portfolio input

Business & risk strategy

• What makes the business case profitable?

• What could endanger our business case?

• Where are the considerable concentrations (products, customers, markets) ?

• What are the biggest threats of our strategy?

• “What if” strategic decisions fail (e.g. acquisition, capital increase)

• On which economic drivers does the business case depend?

• What are macro-economic expectations?

• What about business cycle effects?

• What are unlikely by possible economic crisis?

• How would counterparties, customers and competitors be effected by a crisis?

Normal case planning scenario

Best case planning scenario

Stress case planning scenario 1

Stress case planning scenario 2

Stress case planning scenario 3

Translation of strategy into targets as well as business, risk and capital planning requires planning assumptions

Definition of planning assumptions

HIERARCHY OF STRESS TESTS

Global scenarios

Scenario analysis

Sensitivity analysis

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LINKING MACROECONOMIC EVENTS WITH THE TARGET METRIC

Process for thinking through linkage between macroeconomic events and target metric in scenario based layered stress-testing

GDP

Interest rates

Exchange rate

Debt ratio

Asset prices

Consumer sentiment

…

Macroeconomicfactors

Score distribution

Segment distribution

…

Portfolio characteristics

PD

LGD

EAD

Utilization

Attrition

Response

Delinquency

Process costs

…

Risk drivers

Portfolio loss (Accounting)

Portfolio loss (Economic loss)

Provisioning/Write-offs

Cap. Requirements

Reduced margins

Breakdown of new business

Fall in share price

…

Target metric

Historical:

Earthquake

Recessions

Credit crises

Hypothetical:

Extended recession

Correlation of events

. . .

Macroeconomicscenarios

REVERSE STRESS TESTING – TEST TO DESTRUCTION

Reverse stress testingReverse stress testing should be modelled through various stresses and consider factors relating specifically to the firm as well as the external environment.

Considerations when devising tests: Proportionality Basis of scenarios: hypothetical v

historical Internal v external shocks Idiosyncratic v market wide stress Rapid crystallisation versus protracted

impact Solo v Group

It should be used as a risk management tool – not a means of directly increasing capital requirements

Scenarios that could lead to

business failure

Mitigating actions or triggers for future action

Why do it?

■ Explore business model vulnerabilities

■ Engage senior management

■ Confront possibility of failure

■ Make decisions that better integrate risk management

■ Improve contingency planning

■ Inform stress testing framework

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EMBEDDING THE STRESS TESTING PROCESS

Suggests credit risk relevant scenarios covering bank wide, regional, portfolio or product specific credit risks

Suggests scenarios in ALM, market and liquidity risk

Suggests scenarios on external, fraud, litigation, IT or compliance risks

Suggest strategic, bank-wide and business case specific scenarios

Credit Risk Department

Market Risk Department

Operational Risk Department

Management / Business

First Pass Quantification

Workshop o better understand scenarios and underlying risks

Risk acts as moderator and supplies basic portfolio parameters in order to allow quantification

Discussion based quantification to extract insights before more rigorous first pass quantification by central team

Review of first pass

quantification Central project team

All scenarios are assigned a rough probability and impact

Prioritisation –Pilot Scenarios

Select based on probability and impact

Pilot scenarios based also on variety

Additional second tier risks to be covered later or at less accuracy

Review of selection

Reviews selection of pilot scenarios with representatives from (Sen.) Management, Business, Risk

Final Scenario Quantification

For each scenario estimates for probability and impact are justified by using various sources

Macro model (recessions, avian flu, real estate), benchmarks (most), theoretical model / distribution analytics (ALM, market, credit concentrations), external data (mis-selling), think tank (ship sunk)

Review of Quantification

Risk functions review results and provide comments, in particular for their own risks

Group risk is ultimately responsible for scenario analysis

Results reported to Management and Business

Senior Management bears ultimate responsibility

Scenario Generation Prioritisation Quantification

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STRESS TESTING DESIGN INVOLVES A LOT OF REFLECTIONS

• Under which scenarios is my business model seriously endangered?• What will cause my business model to fail?• What happens to my business in the next crisis?• Which risk drivers are relevant to my business?• In which scenarios would my largest sensitivities lead to major losses?• Whom in my organisation should I involve in the design, modelling,

parameterisation and evaluation of stress scenarios• How do I translate (top-down) scenarios to relevant risk drivers, and what

severity do apply?• What level of sophistication in describing and modelling of scenarios do I need

to apply to capture their essence?• Which parameters should be shocked (how)? Over what time horizon?• How are second order effects and feedback incorporated?• What do I do with the results of stress testing?• To what degree may I anticipate help from the outside (investors, central bank,

government)?

Design and strategy

Methodology

Implementationand evaluation

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KEY SUCCESS FACTORS WHEN SETTING-UP A STRESS TESTING FRAMEWORK

Adequately involve business and senior management at all

levels of stress testing

Clearly define the perimeter, i.e. the

group on a consolidated level

Identify the variables that have the most

effect on target variables

Clearly identify the target metric, e.g. the P&L, capital, external

rating,…

Validate stress testing results, question and

refine scenarios across time

Create a real risk culture across the organization – get

stress testing out of the risk function

Link stress testing results to action,

e.g. outright acceptance,

evaluate contingency

planning

THE IMPORTANCE OF STRESS TESTING LIQUIDITY

30 July 2007 17 August 2007 17 February 2008 14 March 2008 17 August 2007

15 September 2008 15 September 2008 16 September 2008

13 October 2008 National bail-outs: Germany - €470bn, France - €340bn, USA - $250bn bank nationalization, Spain - €100bn

15-31 October 2008 Tapped national bail-out fundsRBOS, HBOS, Lloyds, Commerzbank, Bank of America, JPMorgan Chase, Citigroup, Wells Fargo, Goldman Sachs, Morgan Stanley and more

“Many banks despite adequate capital levels experienced difficulties because they not manage their liquidity in a prudent manner……The rapid reversal in market conditions illustrated how quickly liquidity can evaporate and that illiquidity can last for an extended period of time…..” Basel 3

LIQUIDITY RISK STRESS TESTING

10 riskdrivers

Wholesale funding

Retail funding

Funding concentration

Franchise viability

I Intra-group liquidity

Marketable assets

Off-balance sheet

Intra-day liquidity

Short term market

disruption

Long term erosion in

funding sources due to

ongoing market

tightening

Name specific concerns

- restricting recovery

Combined stress test

Name-specific rumours and bad news.

Downgrade and negative outlook.

Retail run?

Wholesale run?

Institution specific

(idiosyncratic)

Market wide

(systemic)

Non-marketable assets

Basel 3 prescribes stress testing should consider the two types of stress tests below and combinations of both

Cross currency

First two weeks

Inability to roll over wholesale secured and unsecured funding

Sizeable retail outflow

Reduced intra-day credit provided by firm’s settlement bank

Increase in payments withheld to a clearer

Prefunding for all payments

Closure of FX markets

Intra-group deposits repaid at maturity, intra- group loans treated as evergreen

Multiple downgrade of long-term rating

Idiosyncratic Impact

Out to 3 months

Sustained leakage of funds

Sustained outflow

Gradual return to normality

Systemic Impact

Uncertainty of accuracy of valuation of assets and those of counterparties.

Inability to realise or realise particular classes of assets only at excessive cost.

Risk aversion in funding markets. Uncertainty as to the ability of a significant number

of banks to meet liabilities

LIQUIDITY RISK STRESS TESTING

Core Tier 1 as % of RWAs (base)

Core Tier 1 as % of RWAs (Stressed)

2011 2012 2013 2014 2015

£ m

ns

EXAMPLE OF A CAPITAL STRESS TESTING

Economic variable Year Base Case Regulatory mandatory test

Eurozone Sovereign

US GDP 2013 2.4% -1.8% -2.1%

Unemployment 2014 7.2% 13.4% 13.5%

House Price Index 2015 4.5% -13.1% -14.7%

Euro GDP 2013 2.2% -1.6% -3.9%

Unemployment 2014 7.1% 13.1% 15.2%

House price indices 2015 -2% -18.2% 19.1%

Illustrative numbers