Banks have historically relegated stress testing to afterthought status, with the goal of providing the numbers regulators require rather than building scenarios that yield valuable data and actionable insight. Those days are gone.
With debate on financial institution reform ramping up in Congress, the U.K.'s Financial Services Authority announcing another round of more stringent stress testing, and continuing financial reform discussion in the European Union — not to mention continuing strains on the economy and an ongoing trial in the court of public opinion — institutions still face challenges in recovering financial strength and restoring confidence. Stress testing must play a role in helping them meet these challenges.
The credit crisis of the past year and a half has illuminated the limitations of legacy stress-test procedures. The siloed nature of stress testing at most banks — where each line of business conducts its own tests, at different times and with different definitions — ultimately yields an inconsistent and inaccurate assessment of enterprise-level risk. Meeting today's business needs and expanded regulatory requirements means casting old notions aside and moving away from the siloed approach and toward an integrated, enterprisewide stress-testing program.
A centralized and holistic approach to stress testing — one that enables institutions to centrally define and manage scenarios and shocks for a consistent approach enterprisewide — is necessary to assess risk appetite under extreme scenarios. This approach delivers the speed and accuracy that banks require to adapt to constant market changes and deliver stress-testing results quickly, which is essential as regulators increasingly request faster turnarounds.
For C-level executives, a holistic approach enables them to assess the bank's risk appetite and identify risk hot spots. It also provides the information required to plan for business growth and allocate scarce capital — based on risk appetite — to business units.
With holistic stress testing you can identify and control liquidity risk both from a bank-specific and marketwide perspective, in accordance with regulatory requirements. More accurate liquidity stress testing will be critical to helping banks avoid extreme adverse events.
Further, you must ensure you have the agility to execute model-based and deterministic stress tests over time and across all key risk areas, which will enable more strategic decision-making regarding current and future capital risk.
A holistic approach to stress testing also can serve to support compliance initiatives, because it can ensure a transparent and auditable process that can clearly demonstrate organization-specific risks and mitigation plans to reviewers and regulators.
The mission is clear, but many struggle with first steps. To begin, a bank must:
Define the measures it needs to submit to stress testing. This list should include elements from the assets and liabilities segment of the balance sheet as well as income and liquidity areas.
Identify a standard stress-testing approach for each of the risk measures. The complexity of methodologies may vary depending on the nature of the variable.
Establish a centralized repository. To ensure consistent testing, banks should develop scenarios and models from multiple sources of input and using multiple techniques. With a centralized repository for scenario and modeling information, banks can collapse data silos and gain an enterprisewide view of the impact of a particular scenario across all books of business.
Define scenarios consistently. Banks should identify specific risk factors — such as gross domestic product, unemployment rate, sovereign interest rate term structure, energy prices and stock indexes — to serve as economic indicators.
Ensure the appropriate IT infrastructure. This is necessary to support these centralized repositories and enable an enterprisewide stress-testing approach.
By moving beyond these cultural and technological hurdles to adopt a holistic approach to stress testing, banks will reduce institutional risk, improve stability and position themselves to thrive. On a higher plane, they can play a vital role in jump-starting the restoration of public trust in global financial systems.