A New Generation of Stress Testing Processes: Respond to the AQR and 2014 EU-Wide Exercises

The evolution of the post-crisis financial regulatory reform agenda has positioned stress testing as a key tool in assessing the system-wide safety and soundness of financial institutions. Stress testing is a scenario-contingent analysis of the risk that an institution may face. It helps institutions put in place capital and liquidity contingency measures, develop risk appetite, drive strategic business planning, set risk limits, identify portfolios’ vulnerabilities and opportunities in terms of risk-return trade-offs, and determine the optimal timing of strategic and risk management decisions.

Forecasting revenue, expense, portfolio losses, and capital ratios plays an essential part in a stress testing framework. Capital ratios are critical to meeting shareholder and internal stakeholder expectations as they ultimately indicate the solvency of the institution. The forecasts, in turn, affect balance sheet composition, business strategy, and return metrics (e.g., Return on Equity). Therefore, stress testing metrics are usually projected under multiple scenarios as their evolution drives regulatory and risk management decisions.

Stress testing has also become a core regulatory tool to assess the stability of the financial system, enhancing shareholder and market confidence by disclosing the risk tolerance of financial institutions. For example, US bank holding companies have to project loss and income metrics for stress testing reporting and capital planning purposes (Comprehensive Capital Analysis and Review, or CCAR) over nine quarters under a series of forward-looking stress scenarios. The projections consider credit migrations of multiple asset classes, income-related metrics (e.g., via pre-provision net revenue or pre-provision profit for European banks), and they consider all of the bank’s portfolios (e.g., retail, commercial and industrial, real estate, etc.). In addition, very granular data, at a loan or facility level, have to be provided to the Federal Reserve on a regular basis. The Fed uses this data to formulate its own analysis at both a system and institution level and to challenge the forecasts submitted by individual institutions.

The Bank of England has released a discussion paper¹ that proposes a new framework for stress testing the UK banking system. They are proposing an annual stress test to assess banks’ resilience, monitor the UK financial system’s stability, and enhance capital and risk management practices at banks. This framework will be a core component of the capital and liquidity standards of the Bank of England and facilitate granular, high-quality data to the regulator for ongoing supervision. The results of the test will be made public, which is similar to the ongoing CCAR disclosure process in the US.

There are other significant similarities between the Bank of England’s proposed framework and the Federal Reserve’s CCAR. For example, the goal of both frameworks is to assess an institution’s capital adequacy and the solvency of the banking system. The Bank of England will apply its own models to banks’ data to produce its own projections of both individual bank portfolios and system-wide. The results of these projections will be compared with those of the banks. Moreover, the regulator also expects that institutions will develop their own models and scenarios to reflect their unique characteristics in terms of balance sheet composition and risk profile. This closely follows the Federal Reserve’s stress testing methodological guidelines.

Furthermore, similar to the Federal Reserve’s CCAR framework, the results of the stress testing exercise are expected to be used by the regulator as key inputs to banks’ capital planning approval process, which may entail decisions on policy actions if regulatory requirements are not met. Namely, the Bank of England can actively apply supervisory responses (for example, actions on retained earnings, changes in dividends policy) to those institutions that reflect a poor performance during the tests in order to remedy potential future capital shortfalls. This has been proved to render the Federal Reserve’s stress tests useful for investors and the wider public from a risk disclosure and credibility perspective.

In terms of coverage, the major UK banks would be subject to this exercise in 2014. Going forward, the Bank of England plans to include foreign subsidiaries of global systemic institutions and medium-size banking organizations. This would be aligned with the Federal Reserve’s stress testing requirements for medium-sized banks (via DFAST guidelines).

Finally, the Bank of England is considering the development of a specific stress test to assess the counterparty credit risk of clearing houses, given their importance for system-wide financial stability purposes.

Whilst the CCAR has been proven to work in the US and has become an example that could be used by regulatory institutions around the world, a similar framework in Europe has not been possible yet given the following:

• A lack of a harmonised framework and set of definitions to accurately assess, quantify, and compare loss projections across institutions under different jurisdictions, as well as a lack of agreement over which regime should be used for stress testing purposes (e.g., Basel III fully deployed or transitional, etc.).
• The need for political consensus on how to deploy the European funds - for example, how to use the European Stability Mechanism, or ESM, to recapitalise banks that may fall below reasonable capital levels under the stress testing exercise.
• The existence of multiple regulators across jurisdictions and countries with inconsistent regulatory rules, which, combined with a lack of a single regulator with enforcement powers, makes a true euro zone banking union less feasible.

Whilst there is still much work to do, the European authorities and financial institutions have been successfully working on these challenges and taking the appropriate steps during the last few months.

For example, the European Banking Authority (EBA) has released a consultative document providing a single definition of non-performing and forbearance loans across the euro zone banks. This document levels the reporting playing field for a very detailed exercise that is expected to shed light on the quality of the balance sheets at European banks (the Asset Quality Review, or AQR) by 2014.

A stress test is also planned in the euro zone in 2014 after the AQR. In addition, other European regulators have already announced a similar exercise for banks under their supervision (e.g., the UK will run a CCAR-style stress test for UK banks in 2014) and similar deployment timelines. At this stage, an ongoing stress testing process that is part of the supervisory framework will be necessary to monitor the health of European financial institutions’ balance sheets and provide credible information about bank and financial system risk to the market on a regular basis. A single, point-in-time exercise is not enough.

A standard set of definitions similar to those suggested by the EBA are also important to successfully compare risk (e.g., risk-weighted assets, or RWA) and stress testing metrics across jurisdictions in the euro zone. Therefore, for consistency, the definitions used during the AQR will likely be the same for the stress testing that will be administered by the EBA in 2014. This, in turn, may affect reclassifications of some portfolios and changes in the reported quality versus accounting rules-based reporting (i.e., International Financial Reporting Standards, or IFRS). As a consequence, capital – already a scarce resource – may be significantly impacted at European financial institutions.

Figure 1. Integration and consistency between finance and risk metrics are the key to an effective stress testing process

Source: Moody's Analytics

Finally, the European Central Bank is expected to act as the lead regulator (single supervisor and responsible for the Single Supervisory Mechanism, SSM) by the end of 2014, which will facilitate having a unified supervisory body in the euro zone and harmonise decision-making and legislation. The European Parliament has also set the basis for consensus on the uses of the ESM so a credible capital backstop plan can be deployed to recapitalise those institutions that may fail, or be close to a certain threshold, during stress testing.

Financial institutions in the euro zone are also starting to enhance their stress testing frameworks to overcome limitations in traditional silo-based stress testing approaches and limitations in loan or facility-level data for bottom-up, granular modelling analysis. Banks are updating their architecture and stress testing processes to streamline the stress testing calculation and reporting, and are also updating the underwriting processes to proactively manage the quality of loans at origination.

Moving toward a realistic, granular, and ongoing stress testing framework, however, brings some key challenges to European financial institutions that must be overcome to successfully analyse the balance sheet resilience under different scenarios and provide reasonable results that can be leveraged from a business perspective.

The challenges are consistent across regions and institutions, but the priorities are different depending on the current state:

• There is a lack of consistency between the accounting rules and the regulatory guidelines proposed by the regulators for stress testing purposes. Although this is not an issue given that the objectives of both are different and they will not substitute for each other, a reconciliation framework should be in place at institutions to understand the differences in terms of results. At this stage, stress testing methods and analytical outcomes need to be consistent with how financial institutions think about risk and reporting, and at the same time meet the regulatory guidelines.
• Achieving modelling consistency across risk and finance metrics for stress testing and balance sheet forecasting is complex. For example, forecasting conditional new business (including conditional credit spreads) and being consistent at the same time with the credit loss estimation implies a substantial amount of new analytical work. At this stage, the ability to perform side-by-side comparison analysis (e.g., bottom-up versus top-down) provides powerful tools to challenge the business units and understand the business dynamics in the context of stress testing.
• Balance sheet forecasting and monitoring of key performance metrics require the integration of financial planning, treasury, credit, risk management, capital planning and reporting, as well as the linkage to liquidity management. This cannot be done with the current infrastructure at most financial institutions and requires a new generation of architecture and software platforms that not only can streamline and automate the stress testing and balance sheet forecasting calculation, but also can deploy and maintain a large number of models and incorporate auditing and tracking capabilities. At this stage, the scalability of these platforms is the key to maximising the return on investment and considering future requirements as methodologies and regulatory guidelines are continuously evolving.

Figure 2. The Stress Testing Challenge

1 Also called Pre-Provision Profit.
2 No reporting guidelines have been published yet.

Source: Moody's Analytics

Assuming that the AQR, the euro zone, and UK stress tests and the SSM happen according to plan over the next 18 months, European banks should expect that they will be required to make some changes to the way they currently do business. From reassessing the granularity and/or approach to their loss modeling to enhancing their coordination across finance, risk, and business units to automating and streamlining the required reporting for stress testing, banks will face modeling, data, and infrastructure challenges.

Effectively addressing these stress testing challenges, though, will enable bank boards and senior management to make better-informed decisions, proactively create contingency and resolution plans, make forward-looking strategic decisions for risk mitigation in the event of actual stressed conditions, and help in understanding the evolving nature of risk in the banking business (e.g., economic cycle, mergers, acquisitions, etc.). All of this can be viewed at a group level or on a very granular basis and consistently across multiple portfolios, risk types, and jurisdictions. In the end, a thoughtful, repeatable, and consistent stress testing framework should lead to a more sound, lower-risk banking system with more efficient banks.