4.2.4 Stress Testing

4. Stress Testing

4.1 Stress Testing and Other Tools

4.1.1 Definition of Stress Testing

Stress testing involves evaluating the impact of extreme scenarios that are not captured by value at risk($\text{VaR}$).

Generate scenarios $\to$ Test and monitor $\to$ Analyze the results

Stress testing estimates how a portfolio, or a financial institution would perform under extreme market moves.

A key question for financial institutions is whether it has enough capital and liquid assets to survive various scenarios.

Senior management recognizes the importance of stress testing and incorporates it into its decision making.

4.1.2 Stress Testing vs. VaR and ES

Stress Testing	$\text{VaR}$ and $ES$
Forward-looking	Backward-looking
Doesn’t need a loss distribution	Based on a loss distribution
A small range of scenarios(all bad)	A wide range of scenarios (good and bad)
A much longer time horizon	A short time horizon

Enterprise-wide view of stress testing: the scenarios are defined in terms of macroeconomic variables such as GDP growth rates and unemployment rates.

4.1.3 Stressed VaR and Stressed ES

Suppose the year 2008 is used as the stressed period:

Stressed $\text{VaR}$: If we had a repeat of 2008, we are $X\%$ certain that losses over a period of $T$ days will not exceed the stressed $\text{VaR}$ level.

Stressed $ES$: If losses over $T$ days do excess the stressed VaR level, the expected (i.e., average) loss is the stressed.

$T$ is a short period (i.e., one to ten days). In contrast, stress testing usually has a longer time horizon.

Advantages: Stressed $\text{VaR}$ and stressed $ES$ helps financial institutions to set aside adequate capital when the next stress or shock occurs, taking unexpected losses and stressed environments into consideration.

Disadvantages: Because the inputs are stressed, stressed $\text{VaR}$ and stressed $ES$ may not be responsive to the current market conditions, and can not be back-tested.

4.2 Key Aspects of Stress Testing

4.2.1 Choice of Scenarios

The first step in choosing a stress-test scenario is to select a time horizon. Scenarios lasting three months to two years are more common.

Historical scenarios is assumed that all relevant variables will behave as they did in the past. Sometimes, a moderately adverse situation from the past is more extreme for all risk factors to exercise multiplied by a certain amount.

Stress Key Variables is assume that a large change takes place in one or more key variables.

Ad Hoc Stress Tests: History does not exactly repeat, and management judgments are necessary to generate new scenarios or modify existing ones based on past data.

4.2.2 Model Building and Reverse Stress Testing

Construct a model determine how a range of other variables can be expected to behave.

Scenarios (and Ad hoc scenarios) built by emphasizing key variables usually specify only a few key risk factors or the movement of economic variables.

Variables specified in a scenario definition are sometimes referred to as core variables, while other variables are referred to as peripheral variables.

Knock-on effects reflects the impact of how firms (particularly other financial institutions) respond to an adverse scenario.

Reverse stress testing takes the opposite approach of stress testing: It asks the question, “What combination of circumstances could lead to the failure of the financial institution?”

Stress-testing coverage: stress-testing should be applied at various levels (business line, portfolio, risk types, individual exposures or instruments and enterprise-wide basis).

Stress-testing should be conducted over various relevant time horizons.

Capital and liquidity stress testing: we can conduct stress testing for capital and liquidity to analyze how losses, earnings, cashflows, capital and liquidity would be affected.

4.3 Regulatory Stress Testing

In the United States, Federal Reserve carries out a stress test of all banks with consolidated assets of over USD 50 billion. This is referred to as the Comprehensive Capital Analysis and Review (CCAR). Banks are required to consider four scenarios:

• Baseline
• Adverse
• Severely adverse
• An internal scenario

Banks must submit a capital plan, documentation to justify the models they use, and the results of their stress tests. If they fail the stress test because their capital is insufficient, they are likely to be required to raise more capital and restrict the dividends they can pay until they have done so.

Banks with consolidated assets between USD 10 billion and USD 50 billion are subject to the Dodd-Frank Act Stress Test (DFAST). The scenarios in DFAST are like those in CCAR. However banks are not required to submit a capital plan.

4.4 Governance and Basel’s Principles

Governance over stress test

• Governance structure
• Policies, procedures and documentation
• Validation and independent review
• Internal audit

4.4.1 Governance Structure

Governance process: determine the extent of the stress testing carried out by a financial institution.

• A separation of duties between the board of directors and senior management.
• The board and senior management: ensure stress testing covers all business lines and exposures.

Board of directors:

• Define how stress testing is carried out.
• Determine risk appetite and risk culture.
• Determine the procedures used to create the scenarios.
• Determine the way in which assumptions and models are used to evaluate scenarios.
• Should be sufficiently knowledgeable to ask penetrating questions.

Senior management:

• Carry out stress-testing activities.
• Have a deep understanding of how stress tests are carried out.
• Ensuring the organizations is adhering to the appropriate policies and procedures.
• Ensuring that the scenarios change as the economic environment changes and as new risks appear on the horizon.

4.4.2 Policies, Procedures and Documentation

Policies and procedures

• Describe why stress testing is carried out
• Explain stress-testing procedures
• Define the roles and responsibilities in stress testing
• Define the frequency that stress testing to be performed
• Explain the procedures in building and selecting scenarios.
• Explain how independent reviews of stress-testing function
• Provide clear documentation on stress testing to third parities
• Indicate how the results of stress testing are to be used and by whom.
• Be updated as appropriate as stress-testing practices will change as market conditions change.
• Allow management to track how the results of stress tests change through time.
• Document the operation of models and other software acquired from vendors or other third parities.

Documentation
Though documenting activities is often not a popular task, it is important so far as it ensures continuity if key employees leave and satisfies the needs of senior management, regulators, and other external parities.

4.4.3 Validation and Independent Review

The reviews themselves should be unbiased, and it is important that the reviewers of stress-testing procedures be independent of the employees conducting the stress test.

The review should:

• Cover the qualitative or judgmental aspects of a stress test.
• Ensure that tests are based on sound theory.
• Ensure that limitations and uncertainties are acknowledged.
• Monitor results on an ongoing basis.

4.4.4 Internal Audit

The internal audit assesses the practices used across the whole financial institution to ensure they are consistent.

Finding ways in which governance, controls, and responsibilities can be improved.

Providing advice to senior management and the board on changes it considers to be desirable.

4.4.5 Basel’s Requirement of Stress Testing

Emphasized the importance of stress testing.

Market risk calculations based on internal VaR and ES models to be accompanied by “rigorous and comprehensive” stress testing.

Internal ratings-based to determine credit risk capital are required to conduct stress tests to assess the robustness of their assumptions.

4.4.6 Principles

Rationale for stress testing
Providing forward-looking assessments of risk

Overcoming the limitations of models and historical data

Supporting internal and external communications

Feeding into capital and liquidity planning procedures

Informing and setting of risk tolerance

Facilitating the development of risk mitigation or contingency plans across a range of stressed conditions

Shortcoming prior crisis
The involvement of the board and senior management is important.

The stress-testing methodologies used at some banks did not enable exposures in different parts of the bank to be aggregated.