As risk management continues to evolve, so too must one of its most insightful tools: stress testing.
Until recently, and quite understandably, the main focus of banks’ stress testing activities has been banking book credit risk: both a key risk for banks and a priority for their regulators. But for a complete picture of potential risk, a bank must take a more holistic and integrated approach to stress testing and include all the risks the balance sheet faces – from market risk and interest rate risk to non-interest income and expense volatility. Additionally, it should account for not only interdependencies between risks but also practical realities. For example, if developing a stress test for operational risk, does the bank in question have access to the appropriate operational risk loss data?
[For More on This Topic, Check Out: How Legacy Systems and Lack of Data Undermine Stress Tests]
Banks should not take an ad hoc approach to address such a complex challenge. Bankers need to first take a step back to understand the bigger picture before getting absorbed into thinking about smaller details and trying to tackle individual stress testing components in isolation. Most importantly, banks must be goal-oriented and thereby address three key questions:
• What are the bank’s final goals, whether regulatory-driven or business-driven?
• What suitable infrastructure and processes does the bank have in place now?
• How will the bank get from where it is today to its final goals?
I like to call this way of working “gap prioritization,” as it helps the bank identify the most important gaps or building block capabilities that it may be missing to achieve its ultimate stress testing goals. In taking this approach, the bank will need to prioritize each capability. For instance, if it lacks the borrower-level data to carry out loan-level stress testing, the organization may want to stress test at the portfolio level first, in order to achieve an analytical “quick win.”
As well as identifying and prioritizing functional capabilities in this way, banks should consider integration opportunities between stress testing and other strategic risk management processes. Bank risk appetite statements should be informed by stress testing results, which in turn should be linked to a bank’s broader model and risk governance framework.
My recommended approach to sequencing the work to be performed is to develop a comprehensive road map that prioritizes work steps needed to achieve the final stress testing goals, identifies dependencies between individual work steps, and sets realistic timeframes and key milestones. As an example, many banks will be aiming in the long term for bottom-up credit stress testing. This will, however, be dependent on their ability to collect borrower-level data and implement a quantitative risk rating process.
That said, in developing a road map, the bank may actually realize that portfolio-level credit stress testing can be achieved at the same time as collecting borrower-level data and implementing quantitative risk rating models. Therefore, it can fulfill its short-term goals while also building towards a longer term vision of bottom-up modeling.
Whatever a bank’s stress testing objectives, careful coordination and meticulous planning together is the only way to achieve them. For most middle- and smaller-sized banks, holistic stress testing will be a medium- to long-term ambition. But it must be planned today to become a reality tomorrow.
Kenneth Yu is a senior consultant in risk advisory at SunGard Advisory Services.