The wild economic and political ride of the past few years has made stress testing a whole new, higher-stakes ballgame for banks. Improperly measuring the cushion against future volatility is a sure way to wind up on the wrong end of a regulatory action, if not an acquisition.
"When banks used to do credit risk testing, it was straightforward. They looked at the value of the loans they originated. It was an in-house analysis. In today's environment, you have to consider external factors like the economy and what can happen to a credit portfolio in a real downturn," says Shirley Inscoe, a senior analyst at Aite Group.
As a result, stress testing is becoming broader and deeper, and is proving to be an attractive target for firms such as Invictus and Oracle. These firms contend they have upgraded stress testing to work across departments at a bank. Their products are designed to analyze the potential impact of future economic shock on certain types of loans and loan portfolios, and how that impact affects other parts of the bank, such as savings or payments. New techniques also include broader data sourcing that considers the point in the economic cycle that a loan was made, as well as geographic data and information from peer institutions that can drive decisions on capital reserves, liquidity, credit risk and merger strategy.
DODD FRANK, AGAIN
Stress testing software developers owe the opportunity in part to the government. The Dodd-Frank law requires annual stress tests for bank holding companies, state member banks and savings and loan companies with between $10 billion and $50 billion in assets to help determine risk-based capital levels. The Federal Reserve Board, working in consultation with the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corp. (FDIC), in late August said the implementation timeline would likely be September 2013. Regulators are likely going to require greater reporting detail from banks when determining regulatory capital levels. "Profitability is down, the market is competitive and if banks don't make strategic decisions today, it will be too late. The problem is you are implementing a business strategy in an environment where regulators are changing requirements. You are operating in a vacuum," says Kamal Mustafa, CEO of Invictus.
Invictus builds its tests from a combination of marketwide and bank-level data. Its Capital Assessment Model is run quarterly on more than 7,000 FDIC-insured banks using public financial and loan performance data. It also runs more detailed tests using proprietary loan portfolio data from client banks. The "public" tests provide simulations of how banks will perform under certain levels of stress, as well as the adequacy of a bank's loan loss reserves. Invictus uses publicly available loan balance data that's released quarterly by U.S. banks, and combines that data with long-term historical, market and economic data.
When the public data is combined with proprietary data from client banks, the tests are designed to provide estimates of revenue contribution by loan category, and earnings contributions of existing portfolios as loans mature during the stress test's horizon. These factors are designed to measure the bank's capital adequacy through the stress horizon, which affects stock repurchases and dividend policies; and can impact the profitability of strategic initiatives.
Other tech firms are also honing their stress testing. Oracle in August introduced a new financial services enterprise stress testing and capital planning analytics service, an enterprise-wide reporting tool that measures the impact of adverse scenarios on risk and performance while aiding compliance with regulatory stress-test requirements. The product includes templates, a dashboard and reporting tools designed to support compliance with Dodd Frank, Basel III, U.S. Compressive Capital Analysis and Review (CCAR) and Internal Capital Adequacy Assessment Process (ICAAP). It produces on-demand reporting for multiple risk scenarios, helping identify risk and project profit, loss, income and capital. It's also integrated across a bank's departments, and enables testing and reporting for different jurisdictions.
"The regulators are looking to see how the results may affect the overall strategic thinking of the firm. In the past testing was typically done in silos and perhaps on a more academic basis...But the stress testing has to be done more on a holistic basis, what the affect is on the entire institution," says Sabeth Siddique, a director with Deloitte & Touche LLP's governance, risk and regulatory services team Deloitte Consulting.
S. Ramakrishan, group vice president and general manager of Oracle Financial Services Analytical Applications, says stress testing has traditionally ignored the interdependence between the risk and finance functions of a bank. The current regulatory and economic environment requires a holistic approach, he says. "There is some change management with this at bank with a more holistic approach to stress testing. The tech is an important part of that, but there is also a change in process," Ramakrishan says.
Dodd-Frank requires rigorous new stress tests, which is an enticement for tech firms.