“Stress testing as a governance tool” by Christian G. Lauron (Jul 26, 2010)

SUITS THE C-SUITE By Christian G. Lauron
Business World (07/26/2010

Financial firms may resort to a risk management tool, called “stress testing,” to quantify potential vulnerability to future extreme and adverse events.

Ideally, stress tests can help firms gauge the resilience of financial plans by providing an indication of how much capital might be needed to absorb losses in the event of such extreme events.

With the benefit of hindsight, however, it may be said that stress testing seems to have failed in its regulatory purpose and its supposed objective to forewarn management of an impending crisis in sufficient time to take mitigating action.

What led to this failure? Some reasons include:

• Disconnected strategic planning — Stress tests were not incorporated into group strategic plans.

• Inadequate contingency planning — There were no early warning signals and robust contingency plans for a full range of stress scenarios.

• Lack of management buy-in — There were misguided constraints on the range and severity of scenarios.

• Mere regulatory compliance — If any stress testing was done, it was more for regulatory compliance that bore little relation to actual business activities.

• Stress tests in silos — There was a disjointed approach to testing by risk type and failure to share information across the organization.

• Poor methods and execution — Cross-risk and contagion effects were not considered.

These led to stress testing analyses that significantly understated risks and exposures, preventing financial institutions from making prudent decisions.

Such misguided optimism leads to excessive risk-taking; and in the absence of early warning and escalation mechanisms and the lack of a collective appreciation of stress scenarios at the top, institutions end up facing material, or even catastrophic, vulnerabilities.

As calls mount for enhancements in stress testing processes, a consistent theme is the need for a shift in our attitude towards stress testing — that it should be viewed as a governance tool rather than an analytical tool.

The effectiveness of stress testing therefore depends on how the process embedded in a financial institution’s governance.

The governance view becomes particularly relevant as the Bangko Sentral ng Pilipinas resumes its supervisory dialogues with Philippine banks on the latter’s Internal Capital Adequacy Assessment Process initiatives. On the agenda would inevitably be the regular conduct of stress testing, and BSP would be interested in understanding the involvement of the board and senior management.

Some points that can enhance the governance aspect of stress testing that blends supervisory (for which the Basel Committee has issued guiding principles) and management perspectives:

1. Develop an integrated stress testing framework to enable the financial institution to assess the vulnerability of its balance sheet and resilience of financial plans to extreme but plausible stress events.

To become operationally effective, stress testing should be integrated in the institution’s strategic planning process and the calculation model.

Process-wise, integration would mean linking a financial institution’s:

• macroeconomic stress tests, which are applied to assess the impact of an exceptional, but plausible event;

• capital sensitivity stress tests, which are used to understand the effect on the strategic/capital plan of changes in business assumptions; and

• risk sensitivity stress tests, which are managed by risk class heads, these tests isolate the impact on a portfolio’s value of one or more predefined moves in a particular risk factor or a small number of closely linked risk factors.

Model-wise, integration would mean translating the stress test results in terms of impact to earnings, capital and liquidity and providing feedback to the financial institution’s risk appetite (which is sometimes seen as developed a priori).

2. Apply reverse-stress testing.

Financial institutions should adopt reverse stress-testing by estimating the loss that could cause it to fail and working backward to understand the kinds of events and exposures that could prompt this outcome.

This process provides an overall sense-check on the output of the integrated stress testing, and should be employed at the board and senior management level discussions.

Reverse stress-testing could lead to severity indicators and corresponding action steps.

For example, an institution may have assessed that given its business risk profile, a 25-basis-point drop in its capital adequacy ratio is considered an early warning indicator. It will then identify the scenario events and exposures that could lead to such a drop, with management action plans and contingency plans identified and specific accountabilities established.

3. Adopt a forward-looking and interrelated view.

Historical, risk-manager defined, rules-based, correlated, random and arbitrary “shocks” should all be considered, but implicit or explicit reliance on historical data should be avoided.

Institutions should take multi-period, linked stress tests, which provide a more realistic representation of how crises typically unfold and allows the incorporation of systemic transmission and feedback effects.

These points increase interaction between risk and capital personnel with senior management. But the governance objective is to implement strategic discipline on the part of the board and senior management to ask the tough questions on a regular basis regarding the institution’s vulnerabilities and exposures in extreme circumstances.

Regardless of organizational design and sophistication level, financial institutions are prone to “black-box” risk. When there are parts of the process that are not readily transparent or explainable, the stress testing review sessions are sometimes reduced to attacks on the technical aspects and likelihood of assumptions, potentially diluting the opportunity for the board to exercise its oversight function of asking the tough questions.

How can governance be improved here?

There is no perfect approach, but institutions can surgically reengineer their stress-testing processes, particularly scenario identification, where a visual risk map can prove useful for the board and senior management. This risk map will reflect the interrelationship of risk factors from a process where business units apply their judgment objectively to identify the risk conditions and failed business assumptions that could threaten the survival of a business line. Risk experts find ways in which these individual stress scenarios might correlate with each other in an integrated stress scenario that threatens the institution as a whole.

The risk map will also show scenarios of graduated severity (mild, moderate, severe and extreme) that start from the current circumstances and describe how the stresses emerge and compound from a variety of risk factors and events, so that the scenarios are relevant at each level of management.

As the stress increases, and immediate mitigating actions are increasingly inadequate, there is an escalation to the next level of management, for more strategic action. This better reflects the range of potential stresses and deflects an argument about how to calibrate the severity of a single scenario into an exercise of interpolation between different benchmarks. This is where the board and senior management can better appreciate risk interrelationships.

Improvements in stress testing cannot be achieved overnight, but the immediate focus of financial institutions should be on designing ways to obtain management buy-in and the engagement and oversight of the board.

(Christian G. Lauron is a Partner of SGV & Co.)

This article was originally published in the BusinessWorld newspaper. It is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.