Overview of Stress Testing
Every financial organisation as part of its risk assessment tool kit needs to have a stress testing framework in place for each of their business lines. The role of creating and maintaining the framework has traditionally sat with risk methodology teams across market, credit and treasury.
In the past, each part of the business has run desk-based or idiosyncratic stress scenarios that are specific to their product suite. There was a little commonality in shock sizes or views of the probability of an event.
With the introduction of regulatory organisation-wide stress fire drills, larger organisations have overhauled their operational model and have established a centralised team to create a coherent narrative across the products and to coordinate the stress calculations that remain decentralised. Fire-drills such as CCAR have brought on considerable pain as these organisations have to assess the impact from shocking hundreds of thousands of risk factors that drive the valuation of all of a bank’s risk portfolios.
These stress processes
Challenges
The ability to produce a coherent set of scenarios across the organisation has highlighted a number of challenges. These are classified in the following way: –
- Governance. Senior management had not placed much strategic importance on organisation-wide stress testing, and it’s governance through their risk governance structure. Poor governance has led to a lack of influence in business decision-making as part of the strategic risk framework. A lack of central control has led to several adverse effects on the performance of the methodology and its functional implementation.
- Methodology. To build and maintain a stress model that can take economic data and broad-brush scenarios to produce a coherent set of risk factor shocks. These shocks must cover; market risk factors, default probabilities, recovery assumptions, market liquidity and customer behaviour.
- Functional constraints. Immature processes and infrastructure that enable senior management to evaluate the quality of stress scenarios. Organisations struggle to provide visibility of data throughout the organisation due to fragmented risk architecture. Non-integration of risk engines leads to non-sensical aggregate numbers, commonly corrected with manual processes.
These factors have compounded the challenges, giving rise to a process that is time-consuming, compromised and regarded as having little value to the organisation
Stress Framework
At Quant Foundry, we have devised a holistic stress testing framework that combines new methodology that allows an organisation to rapidly configure stress scenarios and facilitate the propagation to other systems in the bank. A means of estimating the impacts across many factors (the scenario enrichment problem) and a means of calibrating the scenarios.
We have coupled the framework with a model that assesses the resilience of the network of banking organisations to significant stress events — allowing you to assess the impact on your liquidity through a reduction in asset values and funding shortfalls.
Developing Scenarios
The Quant Foundry have developed a strategic market monitoring application to anticipate and highlight potential stress events that can be provided across market, credit and treasury platforms to enable consistent and continual monitoring of risk. The app provides insight into the resilience of the bank to default events and liquidity shocks.
The Quant Foundry stress testing process allows for a rapid configuration and scenario enrichment for many regional and global stress events. The rapid configuration allows organisations to quickly map out the impact of stressful events in a coherent and expandable way with full transparency on the process.
The Quant Foundry integrated stress solution provides a means to identify likely candidates for reverse stress scenarios by leveraging the coherent scenario framework.
The Quant Foundry app allows the classification of stress events across different regions, markets. The allows the user to identify and classify the reasons of stress events and provide a means to map scenarios from different regions to others allow rapid scenario construction for events in new economiesd.
Governance
Leveraging on the ability to classify stress events, Quant Foundry has developed a tool that allows users to build a model for the drivers of stress events. The device enables a more quantitative construction and assessment of new stress scenarios. All of this integrates into the core scenario enrichment application to allow the risk team to make quick impact assessments from classes of stress events and assign a likelihood score to the events.
On the governance side, we advocate the formation of a team of stress testing SMEs that can complete a picture of the organisation’s risk landscape. This team of experts includes representatives and quants from business, risk and treasury. The team would report into the strategic risk management (appetite) committee advising and highlighting on the impact of stress scenarios as well as the coordination point to speed up the stress process.
Critical Role
Stress Testing plays a critical role in strategic decision making around risk appetite and liquidity planning. Organisations are now required to perform ever more sophisticated integrated impact studies as part of their regulatory requirements. Organisations are coming under increased pressure to demonstrate the validity of their stress testing process.
The Quant Foundry stress test solution package provides organisations with a robust quantitative coherent framework to allow rapid, coherent scenario generation for strategic and regulatory stress construction.
The Quant Foundry solution provides organisations with a clear view of the potential dangers of each stress scenario and how an organisation could lose money, enhances risk management choices and strategic risk planning.