Extracting Value from Stress Testing

Supervisory stress testing has become a regulatory requirement for financial institutions in most developed jurisdictions since the Global Financial Crisis. Regulators describe a set of conditions, both macro-economic and firm specific, that will impact the firm over a specified horizon. When done well, stress testing, or more aptly referred to as scenario analysis, provides an assessment of the proforma financial statements that would result from adverse economic scenarios. We will explain that all firms, financial and non-financial, can benefit from employing scenario analysis to address a wide array of issues.

In the US, the Dodd-Frank Act mandates stress testing which is referred to by regulators as the Dodd-Frank Act Stress Test (DFAST). DFAST has become a valuable tool for evaluating whether financial firms are holding sufficient capital and the dispersion of capital levels under the different scenarios. This process is comprised of four main steps.[1]

1. Firms must provide the Federal Reserve with standardized data on their securities holdings, trading positions, counterparty exposures, revenues and balance sheets.
2. The Federal Reserve specifies macro-economic and financial market scenarios. These scenarios involve different degrees of adversity and duration.
3. The Federal Reserve inputs the data from the firms into its own models to estimate for each scenario, over a nine-quarter planning horizon, revenues, losses and
4. The results from the exercise are disclosed to the public.

While DFAST is useful, it does not set any capital limits or restrain capital actions (paying dividends or buying back shares). These functions are described in the Comprehensive Capital Analysis and Review (CCAR), where the Federal Reserve assesses the overall capital adequacy of the firms. In particular it assesses whether:

1. A firm has sufficient capital during the different scenarios,
2. The firm’s capital planning processes are appropriate,
3. The firm’s risk management processes are capable of addressing the array of issues that arise in the different scenarios,
4. The firm’s planned dividend and share repurchases impact its ability to remain a viable financial firm.

Compliance with the regulatory requirements impose significant costs upon firms along many dimensions:

1. Collection of data and standardization of formats.
2. The demands on the IT structure within the bank arising from legacy systems.
3. The ability to model the different portfolios within a business and across the bank. This raises the challenging issue of modeling the correlations of revenue and loss drivers across the businesses. Given the need for modeling different macroeconomic environments, this requires an emphasis on understanding the factors that affect the risk drivers.
4. Managerial ability to comply with the increased regulatory requirements. This requires the ability to meet the demands of regulators on a timely basis. It also requires the ability to understand the analysis and to convey the implications to senior management and the firm’s board of directors.

The increase in regulatory compliance comes at a cost. In a recent survey of global and domestic systemically important banks, 25 percent estimated their annual spending on regulatory stress testing exceeds over $100 million USD, with more than half of the banks taking three or more months to complete end-to-end stress testing.[2] However more than half of the banks found that stress testing could help with business planning, budgeting and assessing the risk/return profile. In this paper, we explain how the methodologies underlying the required stress testing can be used to enhance analysis of a wide array of issues facing banks and corporations in general.

It should be noted, though not discussed here in depth, that the management of data collection and reconciliation represents one of the major costs to banks in stress testing.[3] Product and customer data must be accessed across different businesses and geographic locations. Often these businesses collect different types of data and employ different formats. Consequently, different businesses within the bank will have different protocols designed to meet their particular needs. The different IT systems and silo mentality that often exists within a bank, reinforces the desire to maintain different formats and protocols. However, regulatory requirements impose the need for standardization, thereby forcing management to introduce some level of standardization. Introducing this standardization is costly as it involves having to rewrite protocols, change business culture and negotiating compromises across different businesses. The changes often must be implemented retrospectively in order to allow meaningful quantitative analysis.

The increased volume and complexity of regulation places great demands on senior management, risk managers and the board of directors. The demands span two different areas.

1. The bank must thoroughly understand the complex regulatory requirements in order to ensure compliance is achieved and maintained.
2. The bank must successfully undertake the regulatory tests as well as interpret the results. It must also demonstrate that it has effectively challenged extant methodologies.

The platforms designed to comply with regulatory requirements provide management with a set of tools to address some of the challenges facing businesses. In this paper, we show how it is possible to extract value from the different platforms in order to improve decision making abilities.