It is now a decade since the onset of the global financial crisis. Regulatory framework in the financial sector underwent a significant overhaul during this period with strengthening of existing regulations and supplementing with new ones. The regulatory guidance on stress testing has also undergone a rapid transformation. From being essentially a bank initiated internal risk management effort, stress testing has entered the supervisory lexicon. While refining supervisory expectation on Bank’s Stress Testing practices and integrating the process with Bank’s internal adequacy assessment plan ( ICAAP), many central banks have initiated a regime of supervisory stress tests where the Banks respond to supervisor defined stress scenarios.
During this period, first as an advisor to Banks in the implementation of stress testing framework in the Gulf region and later as part of Central Bank supervision, I found, like many others, that Stress testing remains more an art than a science with a lot of judgements, assumptions and unanswered questions.
One such question that inevitably comes up during the implementtion process concerns the scale and scope of the stress test exercise. Should the Stress Testing be performed at a institution level, portfolio level or business line level. For Banks with subsidiaries and branches in other jurisdiction, the relative merits and demerits solo and consolidated level stress testing will arise. Key considerations include the management’s need to understand stress implications, complexity of stress test models, the overall risk appetite of the Bank and the strategic intent for which the stress testing exercise is being conducted. The micro stress tests with specific sector in mind ( real estate for instance) will not give satisfactory answer to balance sheet implecations of overall stress scenarios.
The recent publication by BCBS ” Supervisory and Bank Stress Testing ; range of practices” ( December , 2017) throws some light on the complementarity between micro-focussed and macro focussed stress testing. The data presented in the report highlight that almost 91 per cent of Banks found consolidated group wide stress testing exercise useful whereas 49 per cent focussed on legal entity level ( banks and branches, but not subsidiaries). The supervisors typically focussed on macroprudential stress testing to identify stress impacts on the Bank as a whole.
The general regulatory guidance to Banks in this regard converge upon the need to conduct stress tests encompassing all the material risks, both on- and off-balance sheet that are relevant for the bank on solo and consolidated bases. Depending on the organizational structure and business model of a bank, a complete evaluation of all the risks affecting it would require stress test exercises both at consolidated and at material entities levels within the group. Internationally active banks are expected to perform stress tests at the level of business units in specific geographic regions, business sectors or business lines. The utility of a stress test will come when a consolidated stress test providing the overall impact can also be bisected into regional, sectoral and business line level effects. Therefore the microfoundations of stress testing should be assessed in conjuction with macro level ( bank level) stress testing. Supervisors need to look at the overall sectoral impact of stress scenarios and consider remedial actions to protect the banking sector and ensure financial stability.
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