Stress Testing and other risk management tools

Stressed VaR and Stressed ES

Conventional VaR and ES are calculated from data spanning from one to five years, where a daily variation of the risk factors during this period is used to compute the potential future movements. in the case of the stressed VaR and stressed ES, the data is obtained from specifically stressed periods (12-month stressed period on current portfolios according to Basel rules). In other words, stressed VaR and stressed ES generates conditional distributions and conditional risk measures. As such, they are conditioned to a recurrence of a given stressed period and thus can be taken as a historical stress testing.

Validation and Independent Review Governance

Ensuring that validation and independent review are conducted on an ongoing basis; Ensuring that subjective or qualitative aspects of a stress test are also validated and reviewed, even if they cannot be tested in quantitative terms; Acknowledging limitations in stress testing; Ensuring that stress-testing standards are upheld; Acknowledging data weaknesses or limitations, if any; Ensuring that there is sufficient independence in both validation and review of stress tests; Ensuring that third-party models used in stress-testing activities are validated and reviewed to determine if they are fit for the purpose at hand; Ensuring that stress tests results are implemented rigorously, and verifying that any departure from the recommended actions is backed up by solid reasons.

The policies and procedures should be able to:

Explain the purpose of stress testing; Describe the procedures of stress testing; State the frequency at which the stress testing can be done; Describe the roles and responsibilities of the parties involved in stress testing; Provide an explanation of the procedures to be followed while choosing the scenarios; Describe how the independent reviews of the stress testing will be done; Give clear documentation on stress testing to third parties (e.g., regulators, external auditors, and rating agencies); Explain how the results of the stress testing will be used and by whom; They were amended as the stress testing practices changes as the market conditions change; Accommodate tracking of the stress test results as they change through time; and Document the activities of models and the software acquired from the vendors or other third parties.

Basel Stress-Testing importance

Giving a forward-looking perspective on the evaluation of risk; Overcoming the demerits of modes and historical data; Facilitating the development of risk mitigation, or any other plans to reduce risks in different stressed conditions; Assisting internal and external communications; Supporting the capital and liquidity planning procedures; and Notifying and setting of risk tolerance.

Responsibilities of Senior Management

Implementation oversight: Regularly reporting to the Board: Coordinating and Integrating stress testing across the firm: Identifying grey areas: Ensuring stress tests have a sufficient range: Using stress tests to assess the effectiveness of risk mitigation strategies: Updating stress tests to reflect emerging risks:

Role of the Internal Audit

Independently evaluate the performance, integrity, and reliability of stress-testing activities; Ensure that stress tests across the organization are conducted in a sound manner and remain relevant in terms of the scenarios tested; Assess the skills and expertise of the staff involved in stress-testing activities; Check that approved changes to stress-testing policies and procedures are implemented and appropriately documented; Evaluate the independent review and validation exercises;

Basel Committee Stress Testing Principles

Stress testing frameworks should incorporate an effective governance structure. Stress testing frameworks should have clearly articulated and formally adopted objectives. Stress testing frameworks should capture material and relevant risks and apply sufficiently severe stresses. Stress testing should be utilized as a risk management tool and to convey business decisions. Resources and organizational structures should be adequate to meet the objectives of the stress testing framework. Stress tests should be supported by accurate and sufficiently granular data and robust IT systems. Models and methodologies to assess the impacts of scenarios and sensitivities should be fit for purpose. Stress testing models, results, and frameworks should be subject to challenge and regular review. Stress testing practices and findings should be communicated within and across jurisdictions.

Rationale for the Use of Stress Testing as a Risk Management Tool

Stress testing serves to warn a firm's management of potential adverse events arising from the firm's risk exposure and goes further to give estimates of the amount of capital needed to absorb losses that may result from such events. Stress tests help to avoid any form of complacency that may creep in after an extended period of stability and profitability. Stress testing is a key risk management tool during periods of expansion when a firm introduces new products into the market. There may be very limited loss data or none at all, for such products, and hypothetical stress testing helps to come up with reliable loss estimates. Under pillar 1 of Basel II, stress testing is a requirement of all banks using the Internal Models Approach (IMA) to model market risk and the internal ratings-based approach to model credit risk. These banks have to employ stress testing to determine the level of capital they are required to have. Stress testing supplements other risk management tools, helping banks to mitigate risks through measures such as hedging and insurance.

Responsibilities of the Board of Directors

The Board of directors is "ultimately" responsible for a firm's stress tests. Even if board members do not immerse themselves in the technical details of stress tests, they should ensure that they stay sufficiently knowledgeable about stress-testing procedures and interpretation of results. Continuous involvement: Board members should regularly receive summary information on stress tests. Continuous review: Board members should regularly review stress testing reports Integrating stress testing results in decision making: The Board should make key decisions on investment, capital, and liquidity based on stress test results along with other information Formulating stress-testing guidelines: It's the responsibility of the Board to come up with guidelines on stress testing, such as the risk tolerance level (risk appetite).

Regulatory Stress Testing

This type of stress test is termed as Comprehensive Capital Analysis and Review (CCAR). Under CCAR, the banks are required to consider four scenarios: Baseline Scenario Adverse Scenario Severely Scenario An internal Scenario

Comparison between Stress Testing and the VaR and ES

VaR and ES are backward-looking. That is, they assume that the future and the past are the same. This is actually one disadvantage of VaR and ES. On the other hand, stress testing is forward-looking. It asks the question, "what if?". stress testing largely does not involve probabilities, VaR, and ES models are founded on probability theory. ES and VaR consider a wide range of scenarios that are potentially good or bad to the organization. However, stress testing considers a relatively small number of scenarios that are all bad for the organization. or the market risk, VaR/ES analysis often takes a short period of time, such as a day, while stress testing takes relatively long periods, such as a decade.

the VaR and Expected shortfall

VaR enables a financial institution to conclude with X% likelihood that the losses will not exceed the VaR level during time T. On the other hand, ES enables the financial institutions to conclude whether the losses exceed the VaR level during a given time T and hence the expected loss will be the ES amount.

Types of Scenarios in Stress Testing

historical scenarios, stressing key variables, and developing ad hoc scenarios that capture the current conditions of the business.

Stress testing

a risk management tool that involves analyzing the impacts of the extreme scenarios that are unlikely but feasible. The main question for financial institutions is whether they have adequate capital and liquid assets to survive stressful times.

Reverse Stress Testing

takes the opposite direction by trying to identify combinations of circumstances that might lead financial institutions to fail.