Integrated Risk Framework and Stress Testing
Stress testing is a simple form of scenario analysis where the risk factors of a portfolio undergo sudden changes over a single time step. Stress testing was initially introduced to assess market risk on a daily basis and became more relevant in trading rooms with the advent of derivatives. In recent years, stress testing has improved in sophistication and coverage of risks: credit risk, market liquidity, funding liquidity and operational risk. Basel II has been a catalyst to enhance the use of stress testing as a practical risk management tool. Stress testing focuses primarily on traded market portfolios, given that they can be mark to market easily but can also be extended to loan books.
Historical events such as Black Monday (1987), the Sterling Crisis (1992), the Asian financial crisis (1997) and financial market turbulence due to the failure of LTCM and the Russian default in 1998, highlighted the shortcomings of statistical models such as value-at-risk (VaR). One of the key shortcomings of most VaR methodologies is that the flat tails in empirical distributions, generated by rare events, are not taken into account. Most VaR methodologies approximate the empirical distribution of risk factors to lognormal or normal distributions.
Even when this shortcoming is addressed by considering more sophisticated methods, such as stable paretian distributions or extreme events, there is another limitation that is shared by any statistical model – the reliance on historical observations. For instance, if two currencies have been pegged to one another, they will exhibit a high historical correlation. The risk that one of the currencies may be devalued relative to the other is not addressed when considering a VaR analysis based on that historical correlation. If this is a scenario that concerns the senior management of a bank, a simple stress test will offer more insights than would, say, a VaR analysis performed with a modified correlation assumption. Given these considerations, stress testing which can be based on historical scenarios or hypothetical scenarios is now considered as a supplement to VaR. Although stress testing can be used to assess losses under any scenario, it associates no probabilities with those scenarios. In other words, stress testing complements the VaR in the sense that it makes an educated guess of extreme events that are plausible but not necessarily quantifiable in terms of probability.
The Committee on the Global Financial System (CGFS), which is a central bank forum established by the governors of the G10 central banks, produced a report in January 2005 on stress test practices among 64 banks and securities firms representing 16 countries. Stress tests generally fall into two categories – scenario tests and sensitivity tests. Scenario tests are generally based on either a portfolio-driven approach or an event-driven approach. In a portfolio-driven approach, the key risk drivers of a given portfolio are first identified by looking at its composition and scenarios are then formulated to stress these risk factors. In contrast, in event-driven scenarios the scenario is based on plausible events and is sometimes motivated by recent news, such as a surge in oil prices. This event is then analysed to find the impact on the relevant risk factors in a firm’s portfolio, including the correlations across asset classes.
Under either approach, the scenarios can be categorised as either historical or hypothetical scenarios. Historical scenarios rely on a significant market event in the past, whereas a hypothetical scenario is a forecast of a significant market event. In practice, hybrids are quite common and hypothetical scenarios can be used in conjunction with historical market moves.
Finally, sensitivity tests are tests whereby risk parameters are moved instantaneously by a unit amount, such as 20 per cent decline or 200 basis rise. The usefulness of sensitivity tests lies on the ability for firms to estimate current losses or profits by scaling market moves to unit changes.
The use of stress tests has expanded from the assessment of capital adequacy due to exceptional market moves to encompass a range of applications. These applications are as follows:
The above list of applications can be expanded to other areas depending on the types of priorities and issues that are relevant to a particular firm. Given the diversity of applications, it is clear that stress tests have to be designed with a specific application in mind. For instance, a sudden move in foreign exchange rates can break credit limits while not having any significant effects on capital adequacy. Furthermore, the interaction of different risk factors and their impact on business and capital requirements can only be fully appreciated in the context of an integrated risk framework.
Even the integration of credit and market risks remains a long way off for many firms. However, enhanced IT capabilities have increased the coverage and complexity of stress tests. Hence, the idea of an IT common platform for market risk and credit risk is emerging as an obligatory stage in the path of an integrated risk management framework. Furthermore, it should be borne in mind this is not to say that stress tests should be common across all books, as some scenarios that are appropriate for credit books might not be appropriate for market books, and vice versa. Nevertheless, a common platform allowing all types of combinations of stress tests is the way forward.
One of the issues facing many firms is the inability to develop integrated credit stress tests for both trading and loan books. The key hurdle to an integrated framework, apart from differences in accounting treatment, has been the lack of a universal mark to market framework. Again the ability for a firm to quantify credit exposures in the loan books in a mark to market framework could be a tedious task since it involves present valuation of all cash flows based on credit spreads derived from a risk rating system. However, once a common platform is established, this tedious task is more easily achievable and is very rewarding for a firm, since it allows a risk/reward analysis that gives a competitive edge in terms of pricing and positioning in the market place.
Stress testing is becoming an integral tool for risk management and business decision making in banks and financial firms. Even though there is no best practice on stress testing and industry practices still vary widely, there is a growing consensus about integrated risk management. Stress testing has to allow ultimately the alignment of interests between senior management and business lines. The introduction of common platforms is an important building block for the further development of stress testing capabilities.