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What Is Stress Testing In Banking

What Is Stress Testing Federal Reserve

What is stress testing?

The Dodd-Frank Act stress testing is a complementary component of CCAR that is conducted by the Federal Reserve and financial companies supervised by the Federal Reserve to assess whether institutions have sufficient capital to absorb losses and support operations during adverse economic conditions.

Define Scenarios Using A Multidisciplinary Approach

Many banks use committees to define and review stress scenarios and to reinforce participation across the institutional boundaries. Some organisations have created departments focused on the sole task of developing and managing enterprise stress testing. Such groups typically use external scenarios as benchmarks that assist in developing specific internal scenarios. Moodys Analytics recommends this as a best practice. Defining scenarios that are useful to business lines, as well as the risk and finance functions, require the effective participation and cooperation of multiple teams and specialists.

Additionally, embedding risk culture in decision-making across business units and functions, whilst essential, remains a challenge for many banks.

Frequency Of Stress Testing

The stress testing rule requires a covered institution to conduct a stress test every other year, on even-numbered years, unless it is consolidated under a holding company that is required by the Board of Governors of the Federal Reserve ) to conduct an annual company-run stress test. Generally, covered institutions subject to Category III standards will only conduct company-run stress tests in even-numbered reporting years . While the annual stress test requirement applies to covered institutions subject to Category I or Category II standards.

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Analyze The Financial Impact Of Adverse Economic Scenarios

Bank stress testing is a framework for analyzing the financial impact of unfavorable economic scenarios to ensure that banks have sufficient capital to maintain operations during such situations. After the failure of standard bank stress testing to prevent the global financial and economic crisis in 20072008, regulators around the world promptly expanded the scope and degrees of unfavorable scenarios in order to limit or prevent another systemic failure in financial services.

Currently, requirements for bank stress testing are among the most important risk regulations in the financial services industry. Examples of bank stress testing required by regulation include:

  • CCAR and DFAST by the Federal Reserve
  • EU-wide stress testing by the European Banking Authority
  • Annual industry stress test by the Bank of England

To perform bank stress testing, risk managers use various mathematical and statistical techniques to calculate the financial impact per economic scenario, including:

Stress Testing The Banking Agencies

Stress testing of banks: an introduction

    I. Introduction

    Over the decade since the collapse of Lehman Brothers in 2008, financial regulation has undergone its greatest transformation since the Great Depression. During that period, one legal development that stands out as particularly novel and important is the emergence of banks stress tests as regulatory tools.1 Indeed, the rapid rise of regulatory stress testing is difficult to overstate. The use of those procedures was essentially non-existent until first introduced by the Federal Reserve on an emergency basis in early 2009.2 Yet, due to the perceived success of that experiment, regulatory stress tests were soon after enshrined as a cornerstone of the post-crisis legal architecture established pursuant to the DoddFrank Act.3

    Within the past few years, however, the role of stress tests has come under attack from a wave of reforms which call for those procedures to be rolled back in substantial part or eliminated in full. One source of that pushback is an Executive Order issued by the Trump Administration in 2017, which instructed the federal banking agencies to undertake a comprehensive review of post-crisis financial regulations.4 In response, the Treasury Department has released a series of policy memoranda which set forth a detailed roadmap for overhauling the current stress testing requirements under DoddFrank.5 Congress has been equally active on legislation to the same effect.6

    II. Legal & Historical Background on Financial Stress Tests

    1. At Firms

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    How Are Stress Test Scenarios Constructed

    The stress test scenarios chosen by supervisors should be severe but plausible. They should simulate a serious threat to banks viability while being realistic and credible at the same time. At the OeNB, developing the scenarios for Austria, Europe and the rest of the world, taking into account the characteristics of the Austrian banking system, is therefore a joint effort of the business areas dealing with banking supervision, macroeconomic and financial stability issues. These jointly developed scenarios are the basis for the calculation of risk factors, such as credit defaults or stock prices.

    New Mortgage Stress Test Rules June 2021

    As of June 1, 2021, in order to pass the mortgage stress test, youll need to qualify at your contracted mortgage interest rate plus 2% or 5.25%, which is the benchmark rate used to qualify uninsured and insured mortgages. For example, if you are applying for a mortgage at a rate of 3.65%, then your lender will assess you as if you were paying your home loan at 5.65% since 5.65% is greater than the benchmark rate.

    Because of this stress test, the majority of new homebuyers have had their purchasing power slashed by as much as 20% because theyre only eligible for a lower loan amount at the mortgage stress-tested rates. The new stress test rules have also made it more difficult for current homeowners to refinance or renew their mortgages.

    Impact Of The Mortgage Stress Test On Canadians

    There are two different qualifying rates under the mortgage stress test. Depending on the mortgage interest rate you get, your bank will calculate your mortgage affordability with one or the other. If you were to qualify for a mortgage rate of 3.25 or below, youll undergo the stress test using the Bank of Canada qualifying rate of 5.25%. However, if you qualify for a mortgage interest rate above 3.25%, then your bank will use the other rate which is the mortgage contract interest rate plus 2%.

    Mortgage Stress Test Example

    According to the CMHC mortgage affordability calculator, youll be able to qualify for a home valued up to $637,329* under the 5.25% qualifying rate.

    Before June 1st, 2021

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    Challenges To The Planning Horizon Of Stress Scenarios

    The planning horizon in the U.S. supervisory stress tests is nine quarters. The EBA and U.K. stress tests have somewhat longer planning horizons: three and five years, respectively. The Federal Reserve requires banks to maintain capital ratios above regulatory minimums over nine quarters. However, at the end of the planning horizon, a bank needs to show it has enough allowance for credit losses to cover expected losses for one more year. This means that the effective planning horizon of the U.S. stress tests is a bit more than three years, and more in line with the EBA stress tests.

    Climate change and policy actions designed to reach the Paris Accord target will occur slowly over several decades. Shorter-term scenarios therefore do not allow those risks to materialize. As a result, the ACPR and the BoE are proposing to include scenarios with a planning horizon of 30 years. The scenarios start in 2020 and extend through 2050. In addition, one of the scenarios proposed by the BoE frontloads material risks estimated to occur between 2050 and 2080 to the period before 2050, by adjusting the path of the variables included in the scenario. Banks will be required to use the scenarios to produce projections for expected losses every five years.

    How Do You Do A Financial Stress Test

    Stress Test: What Is Bank Capital?
  • Find out what you need to know about organization and governance.
  • You will be able to define scenarios involving multiple disciplines
  • You need data and infrastructure to perform your third step.
  • In Steps 4, 5 & 6, each key performance indicator is calculated stress-testing.
  • The 6th step is reporting
  • Having a direct dialogue with and engagement with senior management at the core of any action.
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    How A Bank Stress Test Works

    Stress tests focus on a few key areas, such as credit risk, market risk, and liquidity risk to measure the financial status of banks in a crisis. Using computer simulations, hypothetical scenarios are created using various criteria from the Federal Reserve and International Monetary Fund . The European Central Bank also has strict stress testing requirements covering approximately 70% of the banking institutions across the eurozone. Company-run stress tests are conducted on a semiannual basis and fall under tight reporting deadlines.

    All stress tests include a standard set of scenarios that banks might experience. A hypothetical situation could involve a specific disaster in a particular placea Caribbean hurricane or a war in Northern Africa. Or it could include all of the following happening at the same time: a 10% unemployment rate, a general 15% drop in stocks, and a 30% plunge in home prices. Banks might then use the next nine quarters of projected financials to determine if they have enough capital to make it through the crisis.

    Historical scenarios also exist, based on real financial events in the past. The collapse of the tech bubble in 2000, the subprime mortgage meltdown of 2007, and the coronavirus crisis of 2020 are only the most prominent examples. Others include the stock market crash of 1987, the Asian financial crisis of the late 1990s, and the European sovereign debt crisis between 2010 and 2012.

    How To Prepare For The Mortgage Stress Test

    Theres not much that can be done about the benchmark rate and the rate that your lender is charging you, but it would help to have a basic understanding of where you stand before you apply for a mortgage. Ideally, you should chat with a mortgage broker or real estate agent.

    Lenders use a few key metrics when assessing borrowers to make sure theyd be able to pass the stress test and manage mortgage payments, including the gross debt service ratio and total debt service ratio .

    Gross Debt Service Ratio

    Your GDS represents the percentage of your pre-tax income thats required to pay all housing costs. Your lender will not only look at your stress-tested monthly mortgage payment, but the cost of all other monthly expenses, including condo fees , utility bills, and property taxes.

    All of these costs will be added together and divided by your gross monthly income. Ideally, lenders want to see a percentage of no more than 32%.

    Total Debt Service Ratio

    All your debts will need to be factored into the equation as well, which is why lenders will also look at your TDS. This represents how much of your monthly income is needed to adequately cover your debts.

    For more information about your debt service ratio, check this out.

    That includes car payments, personal loans, student loans, credit cards, lines of credit, and so forth. When all of these are added up, your TDS should be no more than 42% of your gross monthly pay in order to get approved.

    Pay Down Your Debt

    Crunch Some Numbers

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    What Is The Purpose Of The Stress Test

    Basically, the stress test was designed to tackle the household debt issue in Canada and prevent consumers from getting themselves into even more debt by taking on a mortgage thats too big for them. In fact, the average household in Canada is indebted at 170% of their disposable income, which means that Canadians owe $1.70 for every dollar they earn after taxes. With the gradual rise of housing and interest rates across the country, many would-be homeowners wouldnt be able to afford their houses in the years to come.

    In an effort to alleviate the countrys household debt problem, the Office of the Superintendent of Financial Institutions Canada proposed some changes to Canadian mortgage and housing rules in July of 2016. One of which is the implementation of a new mandatory stress test for potential homeowners who are borrowing through federally regulated lenders, such as banks.

    Originally, the test only applied to people applying for high-ratio mortgages, meaning those who werent making more than a 20% down payment, and therefore subject to mortgage default insurance premiums. The test also included homeowners with a mortgage term of fewer than 5 years.

    to discover the difference between collateral and conventional mortgages.

    Action Based On Fully Engaged Senior Management

    What is stress testing? Definition and meaning

    Ultimately, stress testing must be part of both the business planning process and the institutions day-to-day risk management practice. Adjustments to asset-liability composition should align with management of concentration risk. Monitoring sensitive limits should provide useful input to risk appetite discussions. Yet 80% of surveyed financial institutions fail to integrate stress testing into the senior decision-making process. Best practices in this area remain a work in progress.

    In conclusion, investing in efficient tools, processes, and systems should help banks turn what is perceived as a labour-intensive, mainly regulatory exercise into an effective tool for business planning and risk management. Easier compliance with regulation and increased transparency in the marketplace should coincide with more confident decision-making.

    Contributors

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    Scenario Modelling As Bau Process

    Scenario modelling should be implemented as part of the BAU process, but from our experience working with many different businesses, this is often an exercise that is overlooked. In many cases, scenarios are run by creating multiple versions of the same model, requiring a significant time commitment for each iteration. A well-built, best practice financial model will allow for quick and easy scenario modelling within a single file. The scenarios would reflect how positive/negative changes to the business key drivers would affect key financial metrics.

    Proactively Understand Your Portfolios Behavior

    Stress testing and capital planning are important for financial institutions in good times, but they are even more important in times of economic uncertainty. With the right support in changing conditions, banks and credit unions can provide top stakeholders with a range of expectations and quickly develop contingency plans.

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    The Use Of Qualitative Findings From The Stress Test Exercise

    Unlike the US Comprehensive Capital Analysis and Review, the EU-wide and targeted ECB stress tests follow a bottom-up approach using significant inputs from the banks in terms of risk exposure and other data. Moreover, European banks generate their stress test projections using their own internal models, the advantage being that the exercise itself requires banks to invest in their risk management capabilities. Another advantage is that the bottom-up approach provides a strong basis for banks to agree with the EBAs detailed disclosure of more than 15,000 datapoints per bank in the EU-wide exercise. However, the bottom-up approach may lead banks to game the exercise and underestimate their vulnerabilities. Over the years, the ECB has addressed the potential for this behaviour by developing a comprehensive system of quality assurance to verify the underlying bank data and to challenge the banks projections against calculations based on the ECBs own top-down models.

    We also draw on stress test outcomes when planning our supervisory activities: for banks that perform poorly in the stress test, we may launch a deep dive or on-site investigation at the banks premises a year later. The results of our stress test have motivated on-site investigations in areas such as data and IT infrastructure and risk and capital management, as well as in more specific fields like credit risk or market risk.

    Q: What Are Some Of The Biggest Unanswered Research Questions About Stress Tests

    What is stress testing in finance?

    A: Stress tests are a major post-crisis innovation in supervision. It is important that they be reviewed regularly to see if they are having their intended effects. Research in a number of areas could be very helpful to ensure they maintain their role to strengthen the banking system and avoid destabilizing the economy. A few questions include:

    • What will be the effects of actual and proposed changes in the stress test program on stress test capital buffers? How would changes in pre-funding shareholder payouts affect the level and countercyclicality of capital requirements from stress tests?
    • Have banks business models become more similar as a result of the stress tests? Is there evidence of increased sensitivity to the same macroeconomic risks, or evidence that banks are ignoring risks not captured in the stress tests?
    • What are the long-run effects of higher capital requirements on the largest banks on aggregate credit supply and welfare?

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    Stress Testing And Bank Capital Supervision

    Fred Furlong

    Stress testing was a potent tool in the supervision of bank capital during the financial crisis. Stress tests can enhance supervision of bank capital by providing a more forward-looking and flexible process for assessing risks that might not be fully captured by risk-based capital standards. The level and quality of capital among large banking organizations has increased notably since the introduction of stress tests during the financial crisis.

    The recent financial crisis raised concerns about bank capitalization, especially among the largest institutions. This is noteworthy given that, even at the height of the crisis, virtually all of the largest banking organizations exceeded general supervisory capital requirements. To assess the capital positions of the largest U.S. banking organizations, the federal supervisory agencies carried out the Supervisory Capital Assessment Program stress tests in the spring of 2009 . Stress testing is a forward-looking exercise assessing the ability of targeted financial institutions to weather the effects of unusually adverse economic and financial market developments on their revenues, asset valuations, and loan losses. The Dodd-Frank Wall Street Reform and Consumer Protection Act calls on federal supervisory agencies to conduct stress tests on large financial institutions. Those institutions will also be required to conduct their own stress tests.

    Capital ratios

    Bank capitalization before the crisis

    Unfolding of the crisis

    Q: Its Been Ten Years Since The Great Recession Ended The Us Is Now Enjoying The Longest Expansion Since Record

    A: Yes. Thats the ultimate test. Until we have another recession, we wont know for sure that a major objective of the stress tests to assure that banks dont amplify a downturn by pulling back on lending when it is most needed has been achieved. To raise the odds that the stress tests work as designed and to guard against complacency as the memory of the Great Recession fades, its important to make the stress-test scenarios more stressful as the economy improves that is, to project a bigger rise in the unemployment rate and greater loan losses and to ensure that banks have prefunded dividends and buybacks in a way that makes that capital available should a bank need to draw on it in a recession.

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