Friday, December 2, 2022

What Is Stress Testing In Finance

The Use Of Qualitative Findings From The Stress Test Exercise

What is stress testing in finance?

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.

Handbook Of Financial Stress Testing

  • Edited by, University of Oxford,, Stanford University,, Oliver Wyman,, University of Oxford
  • Publisher: Cambridge University Press
  • Online publication date: February 2022
  • Print publication year: 2022
  • Email your librarian or administrator to recommend adding this book to your organisation’s collection.

    Handbook of Financial Stress Testing

Supervisory Guidance On Community Bank Stress Testing

These links to various supervisory guidance suggest that community banks use simple stress testing frameworks to assess capital adequacy. My model available for you to download is consistent with this guidance.

  • OCC BULLETIN 2012-33 “Community Bank Stress Testing” states that “or most community banks, a simple, stressed loss-rate analysis based on call report categories may provide an acceptable foundation to determine if additional analysis is necessary.” My stress test contains the core elements described in this supervisory guidance.
  • The FDIC article by Bill Baxter and Tom Lyons titled “Stress Testing Credit Risk at Community Banks” published in Supervisory Insights – Summer 2012 “describes the credit-related stress-testing process and explains how community bank boards of directors and senior management can use this process to better manage risk.”

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Results Of The 2021 Biennial Exploratory Scenario: Financial Risks From Climate Change

We published the results of the 2021 Biennial Exploratory Scenario: Financial risks from climate change on Tuesday 24 May 2022. The Bank of England has run its first exploratory scenario exercise on climate risk involving the largest UK banks and insurers. Launched in June 2021, the exercise was carried out under the Banks stress testing framework, in which biennial exploratory scenarios such as this one are run alongside annual solvency bank stress tests, and periodic stress tests for insurance firmsThe 2021 Climate Biennial Exploratory Scenario explored the resilience of the UK financial system to the transition and physical risks associated with different climate pathways. The CBES used three scenarios involving early, late and no additional policy action, respectively, to explore the two key risks from climate change the risks arising from the significant structural changes to the economy needed to achieve net zero emissions transition risks and risks associated with an increase in global temperatures known as physical risks.

Stress Test Usage Financial Firms

What is stress testing? Definition and meaning

Stress tests are used by financial firms for risk management purposes. They complement a financial firm’s other quantitative risk management tools by providing insights into its risk profile and alerting management to vulnerabilities in the case of exceptional events. Stress testing can also help in efforts to improve governance, data quality, quantitative analytical capabilities and risk management practices. It also fosters greater understanding of the relationship between capital, liquidity and risk. Some financial firms report headline results of a stress test in their annual reports to provide investors with a clearer picture of their financial situation.

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Lets Start With Some Definitions

Stress testing is a simulation technique used to evaluate a portfolio against underlying futures price movement. This can help determine portfolio risk and show how market price movements could potentially impact that portfolio. It also helps our customers identify mitigating or strategic actions and controls for specific scenarios.

Value at Risk shows the maximum loss for a given probability during a certain period of time. A stress test is essentially an exercise to explore how changes in market conditions affect our estimates for VaR.

Types Of Stress Tests

The type of stress testing a bank needs to undergo depends on the size of the bank and the regulations in the country in which it operates. The two commonly used stress tests for banks in the United States are the Comprehensive Capital Analysis and Review and the Dodd-Frank Act Stress Test .

1. Comprehensive Capital Analysis and Review

Banks with more than $100 billion in assets are required to undergo CCAR testing. Financial institutions with more than $250 billion in assets are required to undergo more comprehensive CCAR testing, which may include additional qualitative and quantitative elements than the regular CCAR. Qualitative elements of the test focus more on internal risk management frameworks and policies.

2. Dodd-Frank Act Stress Test

The DFAST is for the largest financial institutions . All banks that fall in the category must satisfy DFAST requirements and send periodical test results to the Federal Reserve.

Central banks of other countries follow similar frameworks for stress testing.

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Types Of Stress Testing

There are three major types of stress testing, that are

  • Stylized scenarios stress testing – In a Stylized scenario stress testing, scientific measures are deployed to check vulnerability in companies as well as ways to maintain efficiency during unfavorable situations.
  • Hypothetical stress testing – In a hypothetical stress testing is based on testing on institutions with peculiar crisis manage them. This is more specific, it measures how a firm hedges a crisis.
  • Historical scenario stress-testing – In a historical scenario stress testing, individual investments and assets are tested using a computer simulation technique based on historical crisis of past events of crisis. Historical crises such as Asian crisis of 1997, the tech bubble of 199-2000 and the 1987 stock market crash can be used. Aside from the three types of stress testing listed above, there are other stress test methodologies.

Why Stress Testing Is Critical For Any Risk Management Practice

What is Stress Testing? | Financial Risk Manager Video Training | FRM Tutorial Video

Stress tests can help you find the strategy that works best for bringing you through a crisis. Stress requirements for the largest financial institutions have contributed to the resiliency they’ve shown through the COVID-19 pandemic, which makes stress testing beneficial in a real, practical sense.

Conditions can deteriorate rather rapidly. The stress test itself can provide a better understanding of risk by providing a more forward-looking view to help you anticipate what’s coming. Heres why its critical:

  • Identify risk: Stress testing will identify areas of heightened risks and potential concentrations of risk.
  • Strategy: Stress testing helps to form the strategy for dealing with risk. Plus, it can also help identify strategies you might currently have in play that could exacerbate unforeseen risks.
  • Communication: The stress test itself can help promote greater communication of risk information throughout the organization.
  • Mitigation: Better communication and understanding can, in turn, help formulate more effective mitigation against those risks.
  • Opportunity: Stress testing can identify potential areas of opportunity that you could take advantage of or exploit to a greater extent.

Stress testing should not be a box checking exercise, because it offers more than just risk mitigation. Stress testing can be opportunity seeking as well. We want to get as much value out of it as we can.

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How To Stress Test In Financial Modeling

One of the easiest methods of stress testing is to test the formula logic built into the calculations of the financial model. A simple sanity test will reveal whether the resulting values make sense. A more robust extension of this test is to fill the formula down or to the right into adjacent cells, and see whether the change properly flows through. Does the filled down formula result in appropriate values? If not, that may mean that there is an overlooked reference within the formula that must be adjusted. As shown in the image below, one of the lines in the statement is not referencing correctly. Stress testing reveals these errors.

Because a financial model relies on the use of assumptions to calculate projected values, it becomes prudent to also stress test the formulas surrounding the assumptions. Test all probable and possible values of the assumptions and see if that crashes the formula. Decrease the assumption, increase it, flip its sign, or make it zero, and see whether the formulas still calculate properly. If, in any case, the formula errors or becomes nonsensical, a further look into the formula logic may be required for that specific assumption.

If multiple users operate within the financial model, check the output values against their copy or version of the model. Are the assumptions similar and do the results match exactly? This is also a good time to ensure that proper formatting has carried over into the new iterations of the model.

Scenario For Banks And Building Societies Not Part Of Concurrent Stress Testing

We published the Solvency Stress Test 2021 scenario for banks and building societies not part of concurrent stress testing on 15 February 2021. This scenario is available for firms to use as a template and severity benchmark to support their own ICAAP stress testing scenario design processes.

In line with Supervisory Statement 31/15 The Internal Capital Adequacy Assessment Process and the Supervisory Review and Evaluation Process , ICAAPs should be updated and stress testing undertaken at least annually.

The scenario is calibrated to robustly test and challenge business models and support firms in identifying key sensitivities and vulnerabilities within their balance sheets in the context of a severe downside outcome with an intensification of the macroeconomic shocks seen in 2020.

This scenario has been derived from the 2021 Solvency Stress Test scenario which was published on 20 January 2021 to support stress testing of the largest UK banks and building societies. The 2021 Solvency Stress Test exercise aims to explore how the banking system can continue to support the UK economy through the on-going stress and will be used as an input into the PRAs transition back to its standard approach to capital-setting and shareholder distributions through 2021.

Given the current economic climate, stress testing remains an important supervisory tool to inform our understanding of the resilience of the sector.

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What Are The Benefits Of A Stress Testing Solution

With new governance-related requirements on stress testing being frequently updated, there is a clear need for a comprehensive stress testing for risk management solution. For larger financial organisations, stress testing is hardly new. What is new, however, is the level of complexity and transparency these tests require.

Current regulations and requirements for robust stress testing means that financial organisations need to be both consistent and transparent with their results. This means centralised data, data provisioning, consolidation and aggregation have become key aspects that need to be considered to meet regulatory requirements.

Problems that some financial organisations face in the pursuit of transparency and accuracy are old systems, inefficient infrastructure and trouble implementing and reporting on risk models. Old systems may result in data silos across the organisation and use inconsistent data definitions, making it difficult to consolidate that data and develop a consistent and repeatable process. Inefficient infrastructure results in disconnected processes throughout the model lifecycle, leading to inconsistencies in the stress testing results. Lastly, financial organisations may not have a well-structured, documented and transparent process that meets regulations, which means stress testing results are often erroneous and fragmented.

What’s The Best Type Of Stress Testing For Your Institution

Financial Stress Test

Your financial institution is unique. Your portfolio mix is unlike that of your competitors, and your capital structure is singular. Regulators recognize that a one-size-fits-all approach to stress testing is not reasonable. You have to figure out what works for your institution.

If you have the manpower internally, by all means, design your own stress test. That’s definitely a good option, and lots of analysis can be done using simple spreadsheets.

Maybe a software model is a more attractive alternative for you. If so, check with your current software vendors to see if they offer a stress testing component or a standalone model.

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Keep Pace With Evolving Regulatory Stress Testing Expectations

Moodys Analytics stress testing suite supports governance and auditability, as well as model risk management, allowing firms to meet the growing demands of the regulatory stress testing process. Transparency with configurable business workflows enables monitoring of disparate business activities for coordinated regulatory stress testing submissions. Our software also facilitates stress testing model development, testing, validation, and implementation, resulting in an enhanced framework to monitor and govern the models used within the firm. Lastly, our centralized data warehouse cross-validates data sources within the firm to ensure data integrity and support daily business functions.

Looking Ahead: New Developments

While the character of stress testing has surely changed over the past decade, the key elements of the EU methodology have remained broadly the same. The EU-wide stress test of 2021 focused consistently on solvency and transparency, while maintaining the bottom-up approach as well as the static balance sheet assumption. Recent developments suggest that these key elements may see changes over the next decade too.

A second novel example is the methodology for the ECB climate risk stress test 2022, which will be a learning exercise for banks and supervisors alike. The aim is to identify vulnerabilities, best practices and challenges that banks are facing in relation to climate-related risk management. The focus is not on solvency and there will not be a direct capital impact through the guidance under Pillar 2. The test takes a modular approach, comprising qualitative questionnaires and quantitative stress test projections. Module 3 entails a bottom-up stress test targeting the transition and physical risks of climate change banks will submit starting points and their own projections based on the ECBs methodology and pre-defined scenarios. For transition risk, the stress test focuses on the potential impact under both short-term and long-term scenarios.

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What Is Stress Testing In Risk Management And Why Is It Useful

Discover the fundamentals of stress testing in risk management and how it can benefit financial organisations.

Stress testing in risk management often involves highly complex, computer-generated simulation models that use hypothetical scenarios as their testing framework analysing how an organisations balance sheet responds to specific situations.

For example, in a period of financial uncertainty, financial organisations can deploy these models to analyse market and portfolio risk and make informed decisions based on the results. Having high-quality data at their disposal following stress tests in risk management will enable financial organisations to be more efficient, mitigate risk and identify problems early on.

From July 2018, under Basel rules, banks must produce stress tests under an IFRS9 basis. In addition, they must also fully document how the stress test results were arrived at. Subsequently, to manage the stress testing process more effectively, mitigate risk and ensure continued regulatory compliance, financial organisations need a single, coordinated stress testing solution to manage their balance sheet.

Considering An Alternative Lender

What is stress testing?

If youre having trouble getting approved for a mortgage from a traditional financial institution or youre interested in avoiding the stress test, you may want to consider choosing an alternative lender. Loans Canada can help match you with a licensed mortgage specialist who can best meet your needs.

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Enhance Your Stress Testing Capabilities

Moodys Analytics supports financial institutions in developing next-generation stress testing capabilities that enhance risk management. Our solutions support bank-wide strategies, enabling you to design and implement integrated stress testing frameworks that can be used across regulatory boundaries. They also support macroeconomic scenario design and implementation, customized to the unique strategies and risks of your portfolio. Enjoy improved coordination and feedback from model development that is integrated across asset classes and lines of business. Moodys Analytics models can be relied upon as the industry standard to be used as challenger models.

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Gain More Data Efficiency At Your Institution

Entering the same data inputs for multiple risk analyses at your institution can be both time-consuming and laborious. With our interconnected systems at Abrigo, users only have to enter information once. Different functions that were once siloed can now seamlessly integrate with each other, all within one trusted platform.

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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.

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