Stress Testing Integration And Methods
Stress testing is an important tool that enables a bank to identify, assess, monitor, and manage risk. Recent financial turmoil has substantially increased the need for flexible, comprehensive, and forward-looking stress testing.
Stress Testing and Risk Governance
Major weaknesses and recommendations for stress testing and integration in risk governances are as follows. Weaknesses: lack of involvement of board and senior management, lack of overall organizational view, lack of fully developed stress testing, lack of adequate response to crisis. Recommendations: Stress testing should form an essential ingredient of overall governance of risk management plan, encompass multiple techniques and perspectives, involve a sound infrastructure and regular assessment, produce written policies and recommendations, and generate comprehensive firm and market-wide scenario testing.
Stress testing methodologies were based on inadequate infrastructure, inadequate risk assessment approaches, inadequate recognition of correlation, and inadequate firm-wide perspectives. Given these weaknesses, recommendations for improvement include development of a comprehensive stress testing approach, identification and control of risk concentrations, and multiple measurements of stress impact.
Stress testing scenarios lacked depth and breadth because they were based on mild shocks, shorter duration, and smaller correlation effects among various markets, portfolios, and positions.
Banks evaluated the risk of complex structured products based on the credit rating of similar cash instruments. However, the nature, magnitude, and sources of risk for these products are different from non-structured products. In order to identify, assess, monitor, and control risk exposure of complex structured products, stress testing plans should utilize all the relevant information about the underlying asset pool, market conditions, contractual obligations, and subordination levels.
Historically, stress testing has not fully recognized funding liquidity risk and its correlation with other risks in times of crises. Future stress tests should focus more on correlations of various factors and risks, including funding liquidity risk.
Stress Testing Principles
Principles for sound stress testing supervision include: assessing stress testing methods, taking corrective actions, challenging firm-wide scenarios, evaluating capital and liquidity needs, applying additional stress scenarios, and consulting additional resources.
