Scenario stress test: In addition to compliance with the law

The well-choreographed steps to compliance

Scenario stress testing has evolved as a tool for banking supervision after the recent financial crisis, and financial institutions have since incorporated these regulatory exercises into their business as usual.

The exercises usually start on a pre-planned date with the release of a known number of supervision scenarios and a specified end date. By design, this structure has enabled institutions to plan resources and coordinate activities to support the process. But this security has also enabled banks to maintain inefficient, resource-intensive processes that limit their potential business value.

For real crises do not begin and end on known dates, and their scenarios are not determined in advance. Will the processes created for this well-choreographic effort serve to prepare an institution to respond to a sudden event?

The expected unexpected of oversight scenarios

As part of the instruction set issued for the annual Dodd-Frank Act Stress Test (DFAST) exercise, the U.S. regulators release a set of three scenarios: one baseline, one unfavorable, and one severely unfavorable. For each scenario, banks are given paths to a set of variables that describe broad macroeconomic and market conditions throughout the scenario timeline. Banks often rely on third-party experts to extend these scenarios across a wider range of modeling variables.

Because the prudential stress tests are used for capital planning, regulators seek to provide stability over time to avoid shocking the banking system. Although regulators have introduced some twists and turns (eg negative interest rates), especially in the unfavorable scenario, the overall macroeconomic patterns used in these scenarios have remained consistent over time.

But in a real crisis, scenarios will not be predetermined, and historical relationships between variables may not hold. Depending on the trigger event, crisis effects may be less broadly focused and may primarily affect certain geographic or product segments. As a result, models may need to be recalibrated or replaced, and more techniques may be needed to construct a mosaic with possible results. Is the stress test process able to adapt to unfolding events without short-circuiting the reporting and control infrastructure?

Creating a true scenario-based stress testing process

Leading institutions recognize that violating compliance with the law and unlocking the business value of scenario-based risk management requires a stress testing process that is much more flexible and efficient than in common practice of supervisory stress testing today.

Here are the questions your institution needs to answer:

Data:

  • Is a sufficient width of fields captured in time?
  • Is the appropriate level of detail maintained throughout the process?

Production:

  • Can the process be started quickly?
  • Can it provide fast turnaround and support multiple cycles?
  • Does it trust that key people in the organization work?

Reporting:

  • Can the reporting process provide decision-makers with timely information?
  • Is there sufficient flexibility to create ad hoc breakdowns and summaries when circumstances change?
  • Can drivers of results be easily identified and summarized?

Modeling:

  • Can the modeling process be changed without disturbing the workflow?
  • Can multiple approaches be implemented and compared?
  • Will bottleneck treatment limit the ability to explore a variety of scenarios?

Management and control:

  • Can the process and the points of uncertainty be fully understood?
  • Are the analyzes properly archived in defense of the actions performed and to facilitate post-mortem review?

Addressing these concerns is likely to require revisions of your existing stress test architecture and possibly improvements to its underlying technological components. Here, managers recognize the synergies between stress tests and the new expected accounting standards for credit losses (eg CECL and IFRS 9) and seek to use their investment to achieve greater utility from scenario-based risk management.