Rethinking Stress Testing
In keeping with the trend to deliver better and more sophisticated ways to understand the global financial markets, new ways of stress testing are is viewed. There were many opinions expressed by different writers which included Dr. Tony Hughes, Anna Krayn and Thomas Day, Nicolas Kunghehean and Dr.Christian Thun. While Dr. Tony Hughes discussed the use of the Comprehensive Capital Analysis and Review (CCAR) as a stress testing mechanism, Anna Krayn and Thomas Day suggested the use of top-down and bottom-up approaches for stress tests. Anna Krayn and Thomas Day, in using the Dodd-Frank Act Stress Testing requirements, said that “an effective stress testing framework employs multiple conceptually sound stress testing activities and approaches.” While top-down modeling is more attractive in the present, they believe that a more comprehensive and holistic bottom-up modeling approach would be ideal for future stress testing practices. Finally, Dr. Christian Thun (2013) said that while banks had to dedicate their enormous resources to comply with CCAR and DFAST, and “treated stress testing like a check-the-box exercise,” it would be wiser if they considered this as an opportunity to manage their business with fewer risks.
Thomas Day discussed the importance of Mid-Cycle Stress Test Disclosures to counter observations about scenarios, loss estimates and PPNR, and disclosures. Because many banks address only a few disclosures, they suffer from ineffectiveness, and so to correct this, they should address all possible disclosures to ensure a more effective discussion around modeling methods. Cayetano Gea-Carrasco and David Little stress on the importance of Liquidity Risk Management and says that it is a Game Changer. There is also the report by María C. Cañamero who says how important it is to prepare for Stress Tests: and the importance of Regulatory Timeline and Requirements. Michael Fadil looks at the possibilities of Stress Testing using RAP or GAAP, and Andrew Jacobs and Stephen Clarke stresses on the challenges of Stress Testing and the US Structured Finance. Jacobs and Clarke stresses on how testing structured finance transactions present unique challenges and that banks need to identify and address hidden risks, develop an industrial-strength, scalable platform to overcome challenges.
Approaches to Implementation
Michael van Steen says that to address the concerns of model risk management framework, institutions should include disciplined and knowledgeable development and implementation processes that are consistent with the situation and goals of the model user and with bank policy. Dr. Tony Hughes, in discussing the Comprehensive Capital Analysis and Review (CCAR) as a stress testing mechanism, says that this would help banks which could use the data collected by CCAR to tide over future bank lending bubbles by projecting much higher losses than actual internal estimates so that a contingency plan can be put in place to overcome any economic crisis. Thomas Day stresses that if CCAR results are to be woven into the fabric of banks, and referenced at all levels of management, the current lack of coordination in stress testing models must be addressed, while Michael Richitelli and Anna Krayn discuss the importance of a CCAR and Basel III intersect, and why data, analytics, and reporting layers of a sound CCAR/Basel III IT architecture, within an integrated platform will meet, and go beyond, regulatory compliance. Dr. Juan M. Licari, Dr. Olga Loiseau-Aslanidi, and Dr. José Suárez-Lledó use the two-step modeling and stress testing framework for the term structure of interest rates swaps that generates sensible forecasts and stressed scenarios out of sample.
Principles and Practices
Andrew Jacobs uses the sample of non-agency RMBS to demonstrate how to approach securitized tranches and the underlying residential mortgage portfolios, and how these challenges posed to financial institutions can be overcome. Dr. Shirish Chinchalkar uses the model building from a bottom-up perspective of mortgages and home equity lines of credit to underscore the importance of loan-level analytics. Alex Kang and María C. Cañamero emphasize the importance of Target Architecture for stress testing. The architecture highlights the need for a solution that will facilitate systems and models integration, data flow coordination, and automated reporting. Brian Heale looks at ORSA as an option to a new risk and capital management environment for insurers, and finally, Victor Pinto and Pierre Mesnard explore the impact of the rapid change in reporting, driven by regulatory and management needs, and how they can be overcome using certain practices.
Moody’s Analytics, (2013), Risk Perspectives, Stress Testing: North American Edition, Vol.2, p. 10-126