It’s reasonable to say that the stress testing process at banks is now reasonably well established. From the early 1990s onwards, and certainly after introducing the “value-at-risk” exposure measurement methodology, banks began to conduct “what if” scenarios. These scenarios help them in their strategic decision-making and set risk limits for different types of credit, liquidity, and market risks.
With the advent of the Basel II and Basel III, regulatory stress testing became much more formalised and is now virtually an “industrial” process for banks. One could say that it’s no longer an end, but merely the means to an end; that end being the production, submission, and approval by banks’ regulators of the “ICAAP” and “ILAAP” documents. These documents confirm not just the capital and liquidity adequacy of every bank, both now and under various stressed scenarios, but also demonstrate how this adequacy in a stressed environment fits into the banks’ overall strategy and mission objectives.
The onset of the market-wide stress event that is national governments’ policy response to the global health crisis has thrown stress testing procedures and capabilities sharply into focus. Unlike in 2008, banks are not part of the problem. However, those same governments are urging banks to be part of the solution. Lending decisions with customers and how those will pan out over time are uncertain at best as the crisis looms on. This impacts the ability to stress test balance sheets comprehensively – requiring banks to create multiple inter-related scenarios to try and predict the outcomes.
Even before the COVID-19 related stress, banks had been investigating more granular stress testing capabilities, such as the ability to:
The demands of stakeholders, including the regulator and shareholders, has led banks to seek more complex and granular stress testing solutions. Some larger banks have looked at agent-based modelling approaches to stress testing. With agent-based modelling, a system is modelled as a collection of individual decision-making entities called agents. Each agent assesses its situation and makes decisions based on its own set of rules. This capability would enable banks to base risk management decisions based on a much more tailored set of circumstances and outputs.
The current market stress has led banks to prioritise the development of granular stress testing solutions and reverse stress testing solutions. The latter process, in which one applies a stress scenario(s) that “tests the business plan to destruction,” has had something of an academic cachet to it ever since it was introduced as part of Basel III. But in the COVID-19 environment, the author recommends that banks apply a reverse stress test now. Subsequently, banks can then work successively “backwards” from it, to determine just how much capital and liquidity resource they can safely deploy as they look to support their customer franchise. Here again, the ability to apply the reverse stress test and then apply slightly less severe scenarios in stages has become a useful tool to assist management decision making.
Many banks currently suffer from lack of flexibility in their stress testing solutions. Indeed, many smaller bank models are simply MS Excel spreadsheets. An ability to apply tailored, portfolio- and customer-specific scenarios at a granular level will significantly assist both the risk management and strategic decision-making process, and allow genuinely value-added risk appetite limit setting. We can safely conclude that the events of 2020 have raised this requirement in the list of banks’ priorities.
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