Stress Testing - Principles, Regulation and Practical Use in Risk Management

• Basel Sound Stress Testing Practices
• Stress Testing and Risk Governance
• Stress Testing Credit Risk
• Stress Testing Market Risk
• Stress Testing Operational Risk
• Integrated Risk Stress Testing and Capital Allocation
• The Role of Regulators in Stress Testing
• The EBA EU-Wide Stress Tests of Banks

The purpose of this seminar is to give you a good understanding of stress testing methodologies and tools and of their practical use in banks’ risk management.

We start with a review of the performance of stress testing during the crisis. Experiences from the crisis has led many banks and supervisory authorities to question whether stress testing practices were sufficient prior to the crisis and whether they were adequate to cope with rapidly changing circumstances.

In response to this, the Basel Committee has developed a new set of recommendations for sound stress testing practices. We give an overview of these recommendations and discuss their implications for banks and regulators.

We then present an overall framework for stress testing and give a thorough explanation of how different types of stress testing are applied to credit, market, operational and liquidity risk.

Methodologies include simple sensitivity tests and more complex tests which aim to assess the impact of a severe macroeconomic stress event on measures like earnings and economic capital.

We explain how to use scenario analysis to quantify the potential impact of historical extreme events, stylized scenarios such as the break-down of correlation assumptions and hypothetical one-off events.

We also explain how to use “mechanical” approaches such as factor push analysis and maximum loss optimization. In each case, we give practical examples and we discuss the practical implementation challenges.

Finally, we discuss how integrated stress testing is used to account for correlations between different risks types and how the results of stress testing are fed into a bank’s capital and liquidity planning procedures. We also discuss the role of regulators in supervising banks’ use of stress testing in risk management and capital allocation. As a practical case study, we look at and discuss the results of the EU wide stress tests of banks that have been performed by the European Banking Authority (EBA).

09.00 - 09.15 Welcome and Introduction

09.15 - 12.00 Stress Testing - Introduction

• What Is “Stress Testing”
• Reasons for Increased Focus on the Need for Improved Stress Testing
  • The performance of stress testing during the crisis
• The Future Role of Stress testing in Risk Management

Basel Principles for Sound Stress Testing Practices and Supervision

• Use of Stress Testing
• Integration in Risk Governance
• Stress testing methodology and scenario selection
• Specific areas of focus
  • The effectiveness of risk mitigation technique
  • Complex and bespoke products
  • Pipeline and warehousing risks
  • Reputational risk
  • Highly leveraged counterparties
  • Wrong-way risk
• The Role of Regulators in Supervising Banks’ Stress Testing Practices
• Case Study: The EBA EU-Wide Stress Tests of Banks

12.00 - 13.00 Lunch

13.00 - 16.30 Stress Testing Credit Risk

• Stress Testing Framework
• Types of Stress Tests
  • Single factor/sensitivity analysis
  • Reverse stress testing
  • Multi factor/scenario analysis
• Types of Scenarios
  • Historical scenarios
  • Hypothetical scenarios
• Examples of Macroeconomic Scenarios
• Connecting Macroeconomic Indicators to Conditional Loss Distribution
  • Connecting factor returns and macro variables
  • Calculating stressed PDs and LGDs
  • Model validation
• Impact of Stress Conditions on a Portfolio
• Covering Corporate and Retail in Economic Capital
• Case Study/Workshop

Friday, November 23

09.00 - 09.15 Brief recap

09.15 - 12.00 Stress Testing Market Risk

• Scenario Analysis
  • Stylized scenarios
  • Creating hypothetical scenarios
  • Mild and severe worst case scenarios
  • Scenario analysis – benefits and problems
• Traditional Stress Tests
  • Factor push analysis (using factor models)
  • Multiple factor stress testing
• Advanced Stress Tests
  • Extreme value theory
  • What happens in a true crisis?
  • Stressed covariance matrix
  • Maximum loss optimization

Stress Testing Operational Risk

• A Stylized ORM Model
• Defining standard Key Risk Indicators
• Risk Drivers and Indicators
• Handling Material Risk Concentrations
• Common Scenarios for OR Stress Tests
• Operational Risk – the Future

12.00 - 13.00 Lunch

13.00 - 16.30 Stress Testing Liquidity Risk

• Institution-specific Shocks
  • Significant downgrade
  • Partial loss of deposits;
  • Loss of unsecured wholesale funding
  • Significant increase in secured funding haircuts
  • Increases in derivative collateral calls and substantial calls
• Systemic Shocks
  • Systemic bank-run
  • Dry-up of market liquidity – “liquidity black holes”
• Case Study/Workshop

Coherent (Integrated) Risk Stress Testing

• Historical/Hypothetical Scenarios which are Common for all Risk Types
• Taking the Correlation between Risk Types into Account
• Diversification Effects and Risk Capital Allocation

Summary, Evaluation and Termination of the Seminar