Why Banks Need to Go Beyond Basic Stress-Test Compliance

Many banks regard stress testing primarily as a regulatory compliance burden. But compliance is not an end in itself. Currently, banks are trying to satisfy stress-test requirements while fending off regulators' notices in the form of matters requiring attention. But the larger goal — and the regulatory requisite — is to make stress-testing framework, analytics and results an integral part of the banks' decision-making process.

Since banks have incurred massive expenditures in order to comply with stress-testing requirements, they also expect their investments to create value down the line. The tools used in stress testing and results can be used to help banks evaluate the marginal risk of prospective transactions in both credit approval and pricing. These tools can also assist banks in setting risk appetite limits in a more standard and objective way. And assessing post-stress test risk-adjusted returns will allow banks to more efficiently deploy their limited capital across various lending opportunities.

However, there are several issues that must be overcome in order for banks to realize the value of their investments in stress-testing procedures and infrastructure. Senior management and board directors, who are ultimately responsible for stress testing and capital planning, continue to be relatively uninvolved in the stress-testing process.

Furthermore, the involvement of the people who actually produce risk — the bankers who are tasked with originating and approving transactions — tends to be virtually nonexistent. Banks' incentive structures still encourage them to continue generating risk by approving loans according to "business as usual." Bankers remain largely unaware of how their decisions may impact business and enterprise risk as well as the bank's ability to meet regulatory capital requirements.

Both bankers and examiners seem to have embraced the letter of the stress-testing regulations by concentrating their efforts on complying with requirements for infrastructure, data, systems, models and processes. Banks will soon complete the automation of most of the stress-testing processes and finish implementing new IT systems. After augmenting their data, building their credit, pricing, stress-testing and challenger models and finalizing their documentation, they will retain only a limited group from the current cadre of stress-test employees. This group will be used for the recurring and repetitive tasks of automated model runs, model validation and infrastructure revision activities.

On the other hand, both bankers and examiners, even after completing numerous cycles of stress-testing exercises, remain a ways off from using stress-testing tools and resources to enhance their business models.

The current skill sets of many bankers will not be commensurate with this objective. Therefore banks will soon need to provide them with additional training or hire a new breed of bankers who can both originate and manage risk simultaneously. These bankers will have to be well-versed in applying credit models at origination, be cognizant of risk and accept responsibility for the consequences of their business decisions. Risk exposure management, regulatory compliance and capital adequacy mechanisms will no longer be regarded as responsibilities exclusive to middle- or back-office personnel. Likewise, future bank examiners will be expected to possess similar skill sets in order to be able to monitor and supervise the new crop of bankers.

In sum, policymakers, senior-level banking regulators and bank executives should realize that merely complying with stress-testing and capital-planning requirements will not take them where they need to go. Stress-testing tools, resources and results can help banks make more informed decisions in their everyday operations — but only if banks step up to the plate.

Ozgur B. Kan is a managing director at Berkeley Research Group.