Stress testing, both regulatory and internal, is aimed at providing a detailed picture of a bank’s current risk position, its key risk drivers, and the main sensitivities of its portfolio. These tests offer a comprehensive, forward-looking perspective on a bank’s full balance sheet and profitand- loss statements, giving the bank an assessment of the combined impact of all the risks it might face.
Because a bank’s assets and liabilities are generally highly diverse and complex, its aggregated risk profile is often not fully understood, especially by senior management or the board of directors. Stress testing can be a powerful tool to increase this understanding. By using the results to evaluate the bank’s business strategy, financial plans, and risk management, senior management can better assess tactical decisions, such as product pricing and divesting a portfolio, against strategic perspectives and targets.
Bank supervisors in different countries and regions, however, take different approaches to how they test their banks. (See “Stress-testing approaches vary.”)
Stress-testing approaches vary
Although some banks began developing their stress-testing capabilities before the financial crisis, at most banks the process was begun more recently and has been driven predominantly by supervisors. How supervisors in different regions approach the process, however, varies considerably.
The European Central Bank (ECB) and the European Banking Authority (EBA), for example, try to enhance financial transparency by ensuring that the results of their stress tests are comparable across all the banks they test. To achieve this, they apply a narrowly defined common adverse scenario and methodology to every bank. This one-size-fits-all approach, however, reveals little about the actual risk position of each individual bank.
In the U.S., the Federal Reserve Board (“the Fed”) tests each bank’s resilience to the particular risks it faces by asking banks to customize applicable models, scenarios, and methodologies to their particular situation. Each bank is expected to run stress tests against two defined scenarios — “adverse” and “severely adverse” — but the requirement goes beyond this on two counts.
First, each bank must design and run a customized “idiosyncratic risk” scenario based on its own specific portfolio, business model, and risks and vulnerabilities. This ensures that the process gives the bank’s board members and management an appreciation of the specific risks they face, and that the test results accurately reflect the bank’s degree of resilience in the face of adverse circumstances.
Second, to ensure quality and consistency, the Fed reviews the validity of the stress models, the accuracy of each bank’s data, and the degree to which the stress test results play a role in management decision making and risk management.
The Fed’s approach is widely acknowledged to be significantly more advanced than its European counterpart. Swedish supervisors, too, stand out for their historical emphasis on stress testing as a supervisory tool. More recently, supervisors in the E.U. have indicated that they will also start to look more deeply into how banks conduct their internal stress tests during the supervisory review and evaluation process, their annual review of capital requirements. At the same time, they plan to apply more scrutiny to the quality of the banks’ stress models and the degree to which the results influence management decisions.
Since banks have generally developed their internal stress-testing models in line with their particular regulatory requirements, they have in turn taken different approaches to how they conduct their internal tests, the models they use, and what they do with the results (Exhibit 1).
Exhibit 2 lays out the results of our survey regarding the degree to which 27 banks across Europe and the U.S. have succeeded in embedding their internal stress test results into their overall management practices. For the most part, banks in Europe conduct stress tests primarily to comply with regulatory requirements. As a result, these banks derive only limited insights into how the results should affect their business decision-making and risk management processes.
Meanwhile, banks in the U.S. and in Sweden have leveraged their supervisors’ more complete and individualized approach to stress testing to perform stress tests more frequently than required, apply more enhanced scenarios, and use the results not only to comply with regulatory requirements, but also to influence their risk management and operational, financial, and strategic decision making. Several banks elsewhere in Europe have also chosen to go beyond their regulators’ requirements.