Is Stress Testing Worth the Investment?

Risk practitioners have asked whether or not stress testing is worth the investment. More precisely, is it likely that the attention to this topic will fade after the current regulatory push? Will all banks sufficiently support their stress testing capabilities to embrace the implementation of an effective process?

Throughout this publication, we have taken a closer look at the opportunities and challenges of stress testing in Europe – from an overview of the current dynamic and regulatory updates to implementation and best practices. And although we are years into the resource-siphoning scramble to stay compliant with regulations, there is still much more to do.

In a previous article, Christian Thun addressed the question ‘Are regulatory stress tests just cost without value?’ Some banks may believe this to be the case, especially if the ever-increasing data requirements of the tests have little to do with a bank’s individual risk profile.

Complying with regulation has never been easy; yet in a very short period of time, stress testing has become both a central regulatory necessity and a key risk management tool. It’s a unique opportunity to contemplate potential outcomes and actions to take depending on different scenarios. However, there are still institutions that opt for a superficial approach, which may expose them to structural weaknesses in a few years.

Regulators are taking stress testing seriously, as reflected in the increase in the level of attention being dedicated to it. The regulatory requirements have also evolved rapidly to become even more complex and place more demands on banks, as described in the ‘Evolution of Stress Testing in Europe’, in an effort to restore confidence and calm in the financial system by bringing transparency to bank balance sheets. With that as the context, we looked ahead to what changes will impact the industry in ‘Regulatory Updates’.

1. The introduction of the European Central Bank (ECB) as a unique euro zone supervisor and its decision to run an asset quality review of the balance sheet of every bank, which adds a much higher degree of credibility.
2. Regulatory teams focused specifically on stress testing have been seconded to the ECB from local regulators, giving the Central Bank access to trained resources in a short period of time.
3. Data analysis from the EBA will be performed at a more rapid pace and with increased capacity, as a result of recent investments in their data technology platforms.

More banks are also following the Comprehensive Capital Analysis and Review (CCAR), driven by some of their activities based in the US. The Prudential Regulatory Authority in the UK has also indicated that it ‘would move towards a US-style system’. All of these factors reinforce our impression that a granular bottom-up driven exercise will take place rather than a top-down approach in most of the asset classes.

Figure 1. Types of risk and finance indicators currently stressed

Source: Moody's Analytics

For more information on the US activities, please see Thomas Day’s article ‘A Summary of the CCAR and Dodd Frank Act Stress Tests’.

After years of planning, working on organisational structures, and methodology discussions, top banks now have a clearer view of what they need to do to implement a stress testing framework.

Stress testing has probably taken less time than Basel II to weave itself into banking culture, but its concept is relatively easier to understand than Basel II’s Internal Rating Systems, Probability of Default, and portfolio models. The board members of banks or CEOs are able to easily grasp the idea of stress testing and understand the relevance of GDP figures, unemployment, or oil prices on their exposures.

The relevance of stress testing extends beyond the banking sector. Treasurers of large corporate firms are moving outside their usual comfort zone of buy-and-hold strategies and are including stress testing practices in their risk management frameworks. In fact, they are facing the same issues as banks do from their boards (see our article ‘Stress and Scenario Testing: How Insurers Compare with Banks’). They also want to have high profile discussions around risk appetite and are seeking answers to simple questions such as ‘what would happen if…?’ or ‘what should we do if…?’

As these questions are changing the sponsorship dynamics, decisions to implement the stress testing framework are no longer only driven by requirements from regulators, but also driven by business or a combination of both (see Figure 2).

Figure 2. Main drivers for stress testing (% of survey participants)

Source: Moody's Analytics

On another front, as the demand for stress testing services grows, the quality of supporting services from consultants, products, and software providers will need to become more comprehensive. Software providers have always been active on various fronts (e.g., data, analytics, and software), but it took at least a year to get a comprehensive solution, which includes data inputs and models for various types of risks and asset classes from a variety of different sources. The challenge is to have systems that will be able to integrate risk, mostly from credit exposures and finance, which are components that have not historically shared the same IT and analytical platform.

Banks around the world have devoted considerable time and resources to comply with the new regulatory guidelines and to establish internal frameworks so that they can perform stress tests for different types of risk, asset classes, and business lines. Considering all the collective inputs, stress testing is definitely here to stay beyond the recent regulatory push and is well worth the cost of the initial investment, despite the challenges of implementing the framework. Overall, it is a matter of choosing between the opacity of the past or moving towards transparency and innovation.