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Monday, April 21, 2014

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SRC Insights: Third Quarter 2009

Supervision Spotlight on Stress Testing: A Complementary Risk Management Tool

Today's financial crisis has led bankers and regulators to reconsider how risks are best detected, mitigated, and managed. The lessons learned are being applied to enhance practices in a number of risk management areas, including risk concentrations, off-balance sheet exposures, valuation, and liquidity risk. Renewed emphasis is also being placed on viewing risk from an enterprisewide perspective and using routine stress testing to consider a wide array of potential impacts under various scenarios.

For many years, stress testing has been considered a key component of an effective internal risk management framework. The forward-looking analysis sheds light on inherent risk exposures and offers alternative insight into the potential severity of negative outcomes. The metrics generated help management evaluate capital and liquidity needs under adverse scenarios, inform the setting of risk tolerances, and facilitate the formation of appropriate contingency plans.

The use of stress testing in the banking industry drew considerable attention this year when the Supervisory Capital Assessment Program (SCAP) was conducted. The Federal Reserve described the SCAP as "a forward-looking exercise designed to estimate losses, revenues, and reserve needs for bank holding companies in 2009 and 2010 under two macroeconomic scenarios, including one that is more adverse than expected." 1 Assessments were conducted at the top 19 banks with assets above $100 billion. The interagency exercise was considered part of traditional supervisory activity and normal dialogue with banks.2 Although it does not represent a new capital standard, the exercise will likely have an influence on upcoming reviews of capital adequacy.

While there are no current plans to put other banking institutions through the SCAP, it seems that certain fundamental concepts and practical techniques of the exercise could help inform a variety of other decision making processes. For example, any bank holding company (BHC) that requests to redeem U.S. Treasury capital requires initial approval from its primary federal supervisor. Part of the evaluation process involves confirming that the institution has a comprehensive internal capital assessment process. A bank that engages in a SCAP-type exercise with its primary regulator could help substantiate how well the levels and quality of its capital would withstand severe loss rates and adverse economic conditions.

The use of stress testing is particularly relevant after prolonged periods of benign financial conditions when there may be a greater tendency to become complacent and discount risk. Stress testing is equally important during expansive times when new, innovative products grow rapidly but performance is unproven. In the past, stress tests were often focused exclusively on narrow business lines and failed to capture an organization's broader perspectives. Considering other business functions, as well as senior management's strategic views, makes the overall process more robust and the output more useful.

Effective stress testing does not always require the use of sophisticated models. Basic techniques that couple historical analysis with sound judgment and provide a range of outcomes can prove to be as effective as many expensive computer systems. However, the sophistication of stress test practices should be commensurate with the size, complexity, and risk characteristics of the institution and its portfolio.

Liquidity and commercial real estate (CRE) are two areas where stress testing is extremely relevant today. The heightened emphasis on liquidity stems from sluggish credit market conditions, and CRE concerns are being fueled by rising delinquencies and portfolio concentrations evident at institutions of all sizes. Stress testing offers management important insight into an individual institution's capacity to weather challenging market conditions and better equips management to make educated decisions about strategic direction and risk appetite.

Tests should be designed to assess how well a financial institution's condition holds up during severe, but plausible events. To properly assess a bank's resilience, the institution's condition should be subjected to meaningful shocks of varying severity and duration, including some tail events that fall outside conventional wisdom and, in some cases, may not have occurred previously. The effects of concurrent pressures and the interactions among risks also deserve consideration, since stresses are often correlated. Risks posed by broader market instability and reputational risk must also be factored into the mix.

The overall stress test process should be formally integrated into the bank's risk culture, but remain nimble enough to consider new and emerging challenges. Scenarios should be updated frequently to reflect modified forecasts, relevant emerging issues, and recently introduced product types. The approach and methodology should be documented clearly, and the data should be granular enough to accommodate the needs of decisionmakers. Limitations should be acknowledged and conveyed clearly.

Ideally, the end results of stress testing should be actionable and lead to prompt and effective response. Occasionally, conclusions may be produced, but there may be a failure with properly communicating information throughout the management chain. Having an efficient management information system in place to generate periodic reports will help facilitate this process. It is also essential that the internal business culture be receptive to stress testing and recognize the potential value added.

The use of stress testing as a complementary risk management tool will continue to serve an important role in strengthening corporate governance and increasing the resilience of individual banks and the financial system.

The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.