Stress Testing

Challenge yourself before being challenged

Stress Testing Ernst & Young 2009
Table of Contents
1. Current developments 4
2. Critical steps in developing a stress testing 8
framework
3. Relevant questions to consider 11
4. Establishing and enhancing a stress testing 12
framework in practice
3 Stress Testing Ernst & Young 2009
Amidst a lack of condence in existing projections and risk metrics,
the recent global market turmoil has raised unprecedented levels of
interest fromindustry and regulators in stress testing methods and
results:
The size of losses incurred by banks and the succession of new
write-downs each quarter has obliged nancial institutions to
drop their usual business forecasting and in some cases, to as-
sess whether they would still be going concerns once the crisis
bottomed out.
Other risk measurement tools, such as value at risk and econom-
ic capital, which were based on assumptions of distributions,
have proven to be too optimistic and inaccurate until signicant
recalibration is performed.
The importance of stress testing as a core component of risk man-
agement has been emphasized in the ICAAP (Internal Capital
Adequacy Assessment Process)
1
requirements under Pillar II of
Basel II and supervisors in many countries are looking to banks to
improve the techniques and comprehensiveness of these tests go-
ing forward. Given the strains across the nancial markets, various
central banks and regulators have also enforced the participation of
banks in system-wide stress testing. In Switzerland, the FINMA car-
ried out a stress testing exercise in summer 2009 with a dedicated
sample of banks. The tests were designed to assess whether banks
require additional capital to maintain a well-capitalized regulatory
capital status and to gain condence in the stability of the local
banking market.
Editorial
The current Swiss regulation does not require banks to conduct
stress testing at a portfolio or bank-wide level. However, most
banks anticipate more regulatory scrutiny on linking stress testing
to capital planning. Board members and the senior management of
banks are placing increasing emphasis on internal stress tests for
selected areas on a periodical basis and consequently, are set to
play a more signicant part in appraising and challenging stress
testing results.
The aimof this brochure is to give an overview of the critical steps
towards a bank-wide integrated stress testing framework and to of-
fer hands-on implementation guidance. Discussing the stress test-
ing topic with our clients, we learned that most banks prefer to
adopt a reliable yet pragmatic approach that for reasons of cost
management and reduction of complexity starts fromexisting
processes and stress testing elements and gradually extends to a
fully-edged and sophisticated model including all Pillar II risks.
We are condent that this brochure will give you a good overview
of all relevant issues and that it will help you adopt a pragmatic
approach to stress testing within your organization.
1
Bank for International Settlements: Principles for sound stress testing practices and
supervision, May 2009.
Dr. Marc Ryser
Partner
+41 (0)58 289 49 03
marc.ryser@ch.ey.com
Daniel Martin
Senior Manager
+41 (0)58 289 37 18
daniel.martin@ch.ey.com
4 Stress Testing Ernst & Young 2009
Disclosure: striking a balance
There is a consensus in Europe on the importance of stress testing
but not on the release of results. Whereas US agencies released re-
sults of individual institutions, Switzerland and the EU have not dis-
closed the names of the banks that were tested. The US disclosed
results to help restore condence in the market but Switzerland and
the EU took the stance that by singling out an individual institutions
risks, their access to capital is compromised. Other issues need to
be addressed to allow meaningful disclosure of stress tests. First,
the choice of scenarios, and especially the severity and likeliness of
the scenarios, should be clearly explained to avoid misinterpreta-
tion. There have been criticisms about the recent exercises that the
dened adverse scenarios were actually close to revised economic
expectations by the time the stress tests were completed.
Information on the methods and measures of impact (on earnings,
capital, liquidity), as well as error margins, must be sufcient to
allow comparison of the results over time and across institutions.
Finally, if market participants come to rely on stress test results as
an indication that a bank is a going concern, disclosure by the banks
will require assurance on the reliability of the calculation, through
an independent audit.
From testing individual risks to full
balance-sheet modeling
The focus on banks making stress testing a core part of the control
framework will continue. The Basel Committee denes a stress test
as the evaluation of a banks nancial position under a severe but
plausible scenario to assist in decision-making within the bank. The
termstress testing is also used to refer not only to the mechanics
of applying specic individual tests, but also to the wider environ-
ment within which the tests are developed, evaluated and used
within the decision-making process.
2
The techniques most widely referred to as stress testing can be
described as follows:
1. Current developments
2
Bank for International Settlements: Principles for sound stress testing practices and
supervision, May 2009.
5 Stress Testing Ernst & Young 2009
Sensitivity analysis which assesses the resulting impact of changes
in the models parameters. For example, Basel II requires the cal-
culation of the impact on interest rate risk of a 200 basis point
shift in interest rates. It is also a standard procedure for model
validation, which assesses the range of inputs for which model
performance remains reasonable.
Scenario analysis can use a historical crisis and apply it to the
rms current or projected position. Useful when a historical sce-
nario could re-occur, or is of an appropriate indicative magnitude,
its use is, however, limited when specic events are not applica-
ble or severe enough to impact the rm, or when there are no
suitable historical events for specic risks (as was the case with
the current credit crisis).
Hypothetical scenarios are typically used for extreme tail
events, where data is sparse or not available. Used by many rms
during overall capital adequacy assessments, the technique
allows evaluation of events that are plausible but challenging to
model. These hypothetical scenarios use a mixture of elements
including shocks seen for parts of the portfolio in previous
events, mixed with other purely hypothetical stress elements to
cover the current prole of the portfolio.
Reverse stress testing is used to demonstrate the strength of a
rms capital position by identifying (1) the severity of the
scenarios needed for the rmto fail, or (2) events and develop-
ments causing losses which exceed a given level. The FSA
requires all banks to carry out reverse stress testing to focus
attention on the combination of events which would put a severe
strain on the bank. The results then need to inuence decisions
on capital, mitigating actions and strategy.
These techniques have been applied to varying extent across the
different major risk types:
Market risk stress testing has been an established technique for
many years, with the application of both historical and hypotheti-
cal scenarios and development by advanced banks of multi-factor
analyses.
Credit risk advances in stress testing have largely followed the
implementation of internal rating systems to meet Basel II. Banks
are working on methods to project forward arrears rates and loss
given default for different portfolios. Stress testing of counter-
party credit risk continues to be an area of methodological
development at banks using advanced potential future exposure
models. In the current environment stress testing of structured
products often actually amounts to a line-by-line credit review.
Under Basel II the banks also face issues regarding procyclical
capital requirements (i.e. requirements which rise in a downturn
and fall in a boom). Banks are required under Pillar II to assess
how far capital requirements could rise and are developing a
range of techniques to do this.
Operational risk scenario analysis is a key component
of Basel IIs advanced framework but the sophistication of
approaches varies.
Liquidity risk many banks are now conducting scenario analyses
as a result of the recent market events.
Banks in various countries have had to develop the rm-wide,
cross-risk capabilities required for the assessment of the overall
risks faced by the rmand the capital required to meet the ICAAP
requirements under Basel II. Unlike our neighboring countries, so
far Switzerland has not introduced any concrete ICAAP directives.
Nevertheless, based on the aforementioned developments and
the stress testing and review activities currently being performed
by FINMA in the Swiss market, it can be anticipated that more
stringent requirements may follow and, eventually, that capital
requirement levels may rise.
One type of new approach is balance sheet modelling. Such an
exercise can be summarized as a full modeling of the balance sheet
under adverse conditions or a stressed version of the business plan.
6 Stress Testing Ernst & Young 2009
Figure 1: Insights and recommendations
Linkage of stress testing with strategy process and risk appetite
Critical challenge of stress testing methodology and results
Goal and target measures
Roles and responsibilities
Assumptions, methodology, frequency and coverage
Limits and escalation procedures
Risk mitigation and contingency planning for stress testing results
Documentation and reporting of results
Regular validation of methodology and (re-)approval of policy
Exposure aggregation (risk factor, product, counterparty)
Fast and efcient adaptation and creation of new scenarios
Targeted and ad-hoc stress tests
Combined effects (systemwide, intra and inter-risk factor interactions and causalities)
Broader coverage of target measures: bank wide P&L and economic capital,
liquidity & funding, viability of business model
Broader coverage of scenarios: ad hoc scenarios and integration of specic risks,
reverse stress tests
More involvement of
BoD and top management
Bank-wide
stress testing policy
Robust and
exible stress testing
infrastructure
Bank-wide focus on
scenarios and target
measures
Recommendations
This requires a stressed projection of credit provisions and trading
losses, and a challenge to redemption forecasts, forecasting of
treasury assets and hedging, and assumptions on income and the
cost base, including tax rate. Rigorous analysis means that few P&L
items can be left unchanged. For example, effective tax rates have
moved signicantly in the current economic environment. Adjusting
variables through stress testing may have the effect of changing
the nature of tax assets; for example, fromcurrent to deferred,
which is likely to have consequences for capital adequacy. It also
means that the tax rate for testing purposes may not be the
accounting tax rate.
Insights and lessons learned
Although stress testing is basically not a new discipline, stress test-
ing solutions and approaches are still in a developing phase. In light
of their developing nature and due to the current market turmoil,
various regulatory bodies conducted in-depth analysis of presently
applied stress testing procedures (BIS Jan 09, FSA Dez 08, IIF Jul
08, FSF Apr 08).
Figure 1 provides an overview of the most crucial insights: It is the
clear view of both national and supra-national regulatory bodies
that current solution have to be enhanced and strengthened.
The elds outlined above will be a particular focus and we expect
increased scrutiny on these. As such, rms are well advised to take
these aspects into consideration when engaging in stress testing
projects.
Present techniques and current
views must be challenged in
light of a fundamentally changing
environment.
8 Stress Testing Ernst & Young 2009
Supervisory exercises conducted in various countries showed that
many institutions lacked an efcient rm-wide stress testing frame-
work. Indeed, several supervisors had to extend their original dead-
lines froma few weeks to several months, to grant banks the time
to deliver the results.
It is apparent that rm-wide stress testing is still a highly manual
process with signicant coordination needed to align assumptions
and the projection process between risk, nance, treasury and busi-
ness units. A clearly integrated approach and infrastructure is also
required to efciently aggregate estimates frommultiple models
and link balance sheet and income dependencies. Consistent fore-
casting models are not typically in place for all balance sheet and
income statement categories to support integrated projections.
Modeling capabilities vary across institutions and portfolio types.
The most sophisticated banks have developed macro-economic,
factor-driven loss forecasting models. Other institutions without
these modeling capabilities used more pragmatic approaches based
on historical loss rates, supplemented by expert judgment and
benchmarks.
Many existing nancial forecast models lack sufcient risk granu-
larity to readily support integrated income and loss forecasting.
Beyond market, credit risk and net interest margin, fewapproaches
or established processes exist to robustly project losses and income
statement effects under alternative scenarios to existing baseline
forecasts.
Many institutions have encountered data quality, reconciliation and
data management issues as they set up models, ran the projections
and tried to aggregate across categories.
Given the current unprecedented environment, solutions that
extrapolate fromhistorical data need to be carefully complemented
with management expertise and hands-on business knowledge;
stress tests require signicant management involvement to inter-
pret scenarios, approve assumptions, and business strategies, and
analyze offsetting or compounding risk effects.
2. Critical steps in
developing a stress
testing framework
9 Stress Testing Ernst & Young 2009
Under the Pillar II/ICAAP requirements, presently not implemented
in Switzerland, institutions need to have a repeatable process for
similar scenario analyses, rather than relying on ad hoc solutions.
This requires the following critical steps:
1. Analyze and dene the approach
The scope of a stress testing programmust be determined risk
coverage, risk prole/materiality, and required outputs and
reporting granularity. A review of existing stress testing capabilities
should be performed against these objectives. To establish projec-
tion methodologies that link risk and nance model inputs to macro-
economic factors requires an understanding of the specic risk
drivers within portfolios and their impact on nancial metrics and
portfolio performance. It is also important to estimate the time be-
tween the initial economic shock and the impact on the banks -
nancial situation (the lagged effect). Stress testing must be inte-
grated into the risk management framework/risk governance and
decision-making at the appropriate level of seniority.
2. Choose appropriate scenarios
For stress testing to effectively support senior management
decisions, the number of scenarios must be kept to a handful to be
manageable, while still providing a thorough assessment of risk.
Relevant scenarios must be selected fromadverse variations to
the plan, using the same type of indicators as for baseline business
planning and additional scenarios, given the institutions risk
sensitivities.
Scenarios must then be translated into factors that drive risk and
nance models, developing a set of parameters for each scenario
to stress the key income statement and balance sheet metrics that
measure the banks solvency and liquidity position. Data require-
ments must be dened and assumptions around new business and
risk proles under each scenario have to be established. For larger
institutions, the key challenge is to apply consistent scenario inter-
pretations across multiple risk and nancial statement models, and
design stress testing capabilities at different levels (e.g., bank-wide,
business unit, business line).
3. Build a repeatable process
Execution of the assessment must take place within a clearly
dened and repeatable process. The process must cover the gath-
ering of required data, addressing cases where it may be scarce and
lacking in quality. The application of stress testing solutions must
be supported by the development of an adequate infrastructure.
Process planning must allow for expert judgment review sessions
and workshops where needed. Such an integrated process can
require establishing additional governance as applicable, either
through a distinct stress testing committee involving senior risk
and nance representatives, or through integration with capital
planning committees. Activities must be documented to support
internal analysis and supervisory dialog.
4. Aggregate, report and review results
This was perhaps the step that many institutions found most
challenging during supervisory exercises.
Within a short time frame, institutions must run aggregation of
nancial model and capital projections and produce management
reports explanatory diagnostics, sensitivities, key behavioral
assumptions.
The results must be reviewed to challenge behavioral assumptions
and, if appropriate, calculations may need to be re-run. The
results should be reported to senior management to determine
their action regarding capital adequacy strategy and risk manage-
ment, including potential revision to the business plan. For stress
test results to support decision-making within large institutions,
the calculation and reporting process must provide for appropri-
ate controls and timely delivery of information. One approach
could be to implement stress testing within the yearly budget
process. To ensure necessary management involvement within
businesses, lines, this process must provide relevant business
information. This can be achieved by including not only scenarios
involving severe but rare events, but also sensitivity analysis
of business to potential adverse conditions that could cause
operating income to become negative.
Strenuous training and sound
preparation clear the way for a
stable and more predictable
future.
11 Stress Testing Ernst & Young 2009
Stress testing can involve complex models and infrastructure, is
frequently dependent on expert judgment, and yet it must
be transparent, replicable and reliably able to support strategic
business, capital-planning and management processes. To ensure
its relevance, senior management must oversee the development
of an integrated framework, aligning resources from risk, nance
and business to make sure that key considerations are addressed.
Critical questions include:
What are the most signicant risk types that could materially
damage the rm?
What techniques are presently in place that can already be used
for stress testing purposes?
What should the target stress testing framework be and how
does it match present and evolving market practices?
Is the target frameworks sophistication proportionate to the
size and complexity of the rm?
What meaningful scenarios adequately reect the banks
activity and risk prole?
Are calculation techniques reasonably sophisticated but
straightforward enough that they can be understood by the
management and practitioners?
Have experienced experts such as line managers been
sufciently integrated into the stress testing process in order
to question the validity of the calculated results?
Do underlying solutions sufciently capture the true risk
sensitivities of the banks business?
Are the results aggregated and communicated in ways that are
meaningful to the business?
Is stress testing integrated into the decision-making process,
i.e., a formal element of limit setting and capital allocation as
opposed to being a simple informational tool?
What are adequate and opportune management and
remediation actions that could be foreseen to mitigate the
effects should such stress situations crystallize?
3. Relevant questions to
consider
12 Stress Testing Ernst & Young 2009
The stress testing framework applied should ideally reect the
structure, complexity and business scope of a bank. As such, a
stress testing framework does not per se need to be highly complex
and overly expensive. However, certain elementary components
have to be taken into consideration.
Scope
First and foremost, a bank has to forman understanding of the
scope of stress testing to be applied. As explained above, stress
testing is a generic termsummarizing various techniques and not
all of themare applicable to a specic bank. Figure 2 provides an
overview of the presently observed techniques applied.
A bank will have to identify what means of stress tests it is currently
applying and in which direction it would like to develop its capabili-
ties. Often, lower level and operational stress tests are already im-
plemented in certain risk silos, such as short horizon stressing of
market risk factors in the trading or banking book (these may even
constitute regulatory requirements for some banks). Aligning and
aggregating these silo-based stress tests in a simple way offers a
pragmatic rst step. Later, banks usually start developing broader,
macroeconomic scenarios and linking themto various risk types
and eventually bank-wide target measures, hence commencing with
Pillar II stress tests. First versions of bank-wide Pillar II stress tests
are often based on expert judgment and limited statistical analysis.
During later enhancements, analytical ties amongst the macro-
economic scenarios and the risk drivers may be extended and
strengthened.
Stress testing process
Stress testing is an endeavor that is too extensive to be conducted
only once or on an ad hoc basis. To the contrary, many institutions
decided in line with regulatory requirements to have the calcula-
tions conducted on a regular, often quarterly basis, ensuring contin-
uous oversight of the stress exposures.
4. Establishing and
enhancing a stress testing
framework in practice
13 Stress Testing Ernst & Young 2009
Figure 3 on the following page shows an example of such a stress
testing process.
Stress testing usually starts with the denition of the relevant sce-
nario input parameters and assumptions. Such parameters are then
linked either statistically or based on expert knowledge to port-
folio specic risk factors. In the case of a macroeconomic scenario,
for instance, historically observed changes in GDP would be linked
to the observed development of PD grades per segment, move-
ments in house price indices would translate into Loan-to-Value and
LGD effects. Once such relationships are estimated and established,
they can then be used to project resulting losses fromhypothetical
economic scenarios. This process can be repeated with various
Figure 2: Stress testing landscape
Standard scenario set
Historic worst or
sensitivity-based
Backward-looking
Current risk factors
Ad hoc scenario set
Targeted to specic
positions
Backward or forward-looking
Specic risk factors in times
of stress
(Macro-)economic
scenario set
Calibrated to banks
positions
Forward-looking
Current risk factor
moves, derived frommacro-
economic variables
Out of the box
Scenario set
Reverse stress testing
Forward looking
Current & complementary
risk factors
Viability of banks,
business model
Liquidity and
funding gaps
Bank-wide P&L and
economic capital
Bank-wide P&L and
regulatory capital
Business line P&L
Position values
Post-crisis stress testing
Pre-crisis stress testing
Pillar I stress testing
Scenario sets
Target measures
scenarios in order to test the loss potential under varying
conditions, helping the bank identify the instances that are most
crucial to its existence and future prospects.
A further important aspect is the challenge to conducted calcula-
tions by experienced risk professionals. It is not the notion of stress
testing to replace one mathematical black box with another!
On the contrary, the results generated as well as the techniques
leading to these results should be straightforward to communicate
and uncomplicated to comprehend. As such, seasoned risk profes-
sionals should validate and challenge both the assumptions and
results fromstress tests. Often this is conducted by a stress testing
committee.
14 Stress Testing Ernst & Young 2009
Limitation
Finally, the results reviewed and approved by the committee are
reported to the Executive Management and the Board of Directors.
Based on the insights gathered, the banks governing bodies may
adjust their risk appetite or initiate other means of corrective
action. However, it is important in this context that a sound set of
stress limits are in place. These limits help the bank to reduce its
loss potential and ensure that the maximumlosses are in line with
the banks risk appetite. Such limits are usually reviewed once
per year more often in the case of unusual developments such
as changes in the scope of business or drastic macroeconomic
developments and approved by the banks governing bodies.
Figure 3: Stress testing process
Scenario denition
Scenario 1: Global recession and consumer retrenchment
the GDP in the USA goes down by 3% (each year within two years)
the GDP in Europe goes down by 4% (each year within two years)
the interest rates in the USA go down to 0%
the interest rates in Europe go down to 0.25%
the stock market in the USA goes down by 45% (within two years)
the stock market in Europe goes down by 35% (within two years)
the stock market in the BRIC countries goes down by 15%
(within two years)

Scenario 2:

Stress test result analysis and actions
Stress test result analysis and actions
Limits
Risk capacity and risk appetite
Regulatory and economic capital planning
Risk identication

Regular committee
meeting
Bank-wide stress loss
Input parameters (overall
assumptions) GDP, IR
Stress test model
(regression )
Output parameters
PD, FX
Sensitivities
business line 2
Aggregation
Sensitivities
business line
Sensitivities
business line 1
Macroeconomic times
series
Stress test report
Stress test model
15 Stress Testing Ernst & Young 2009
Executive summary
This brochure outlines the current developments in the eld of
stress testing and their respective importance for banks manage-
ment. Beyond regulatory pressure, the economic added value of a
sound stress testing framework is signicant and initial pragmatic
results can be obtained with reasonable efforts.
Internationally, detailed guidance on single risk and rm-wide
stress testing is evolving. At the moment, the available regulatory
guidance is still rather principle-based. However, as attention on
these areas intensies, more concrete standards are expected to
evolve.
Due to the continued economic uncertainty, volatility of earnings
and evolving capital regulations, rm-wide stress testing also
represents a critical management information tool to supplement
existing standalone nancial and risk metrics. Developing a
sophisticated stress testing framework, however, is a multi-year
effort requiring management direction and infrastructure invest-
ment, with clear denition and prioritization of activities.
Ernst & Young has successfully completed a large number of stress
testing implementation and review projects with a variety of banks
both nationally and internationally. As such, Ernst & Young is
well placed to advise any bank that is reecting on its stress testing
strategy, is in need of concrete stress testing solutions, or would
like to compare its present approaches against current market
practice standards.
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