Regulators have seized on stress testing as central to controlling bank risk and systemic risk. Find out what financial firms have to do, what regulators hope to accomplish, and where the efforts may fall short.

1. Regulatory Requirements
for Stress Testing
Barry Schachter
Courant Institute, NYU (March 5, 2013)

2. Required Risk Measurement
Stress
Reverse Tests
Stressed VaR
Scenario
Stress Tests
Internal
Standard Model (VaR)
Model

3. Regulatory Stress Testing
Requirements for
Capital Adequacy
Liquidity
Threats to Viability
Systemic Risk
Disclosure
Other Risk Management Purposes

4. Liquidity

5. Basel III Liquidity Stress Test
 Liquidity Coverage Ratio
High quality liquid
assets
Cash outflows under
stress (30 days)

6. Assets Liquid Under Stress
 Able to sell, borrow against with no loss even
under severe market stress.
 Level 1: Cash, central bank reserves, securities
backed by sovereigns and CBs
 In unlimited amounts
 Level 2: covered bonds, corporate
debt, RMBS, some equities, some government
securities
 In limited amounts with haircuts

7. Elements of Liquidity Stress
Scenario
 Run on retail deposits
 Partial loss of wholesale funding
 Margin calls from 3 step credit downgrade
 Drawdowns of committed lending lines

8. Liquidity Stress Scenario
 Set out as “minimum” supervisory requirement
 LCR requirement must be satisfied “continuously” in normal times
 Banks must do additional scenarios
 Reflect business-specific activity
 Over longer time horizons
 Share results with supervisors
Basel III: International framework for liquidity risk
measurement, standards and monitoring (December
2010/January 2013)
(bcbs188 and bcbs238)

9. Operational Considerations
 Assumptions – size of run-offs and other impacts
 Data – detailed collateral scenario forecasts
 Operational risks – integrating systems to
aggregate liquidity impacts
 Liquidity adjustments to pricing
 Consistency with liquidity assumptions in VaR

10. Capital Adequacy

11. Rules Apply to Who?
Dodd-Frank (section 165):
Financial HCos., Banks, S&Ls, SIFIs
>$10 billion assets, SIFI >$50 billion
CCAR:
Bank HCos.
>$ 50 billion assets
>$100

12. What Tests? CCAR and D-F
 Dodd-Frank (Sect. 165)
 Annual supervisory stress tests for “SIFIs”, Banks>$50B in assets
 Annual company-run stress tests for Banks and Finc. HCos.
>$10B
 Semi-annual company-run stress testing if >$50B in assets
 Company-run scenarios include a severely adverse scenario
 Minimum of three supervisory scenarios
 Mandated public disclosure
 CCAR
 Annual supervisory severe adverse stress test for
large, complex bank HCos., >$100B in assets originally, now
>$50B

13. Number of Affected Firms
as of Q3 2012
120
100
Bank HoldCos > $100B
80
Fin HoldCos >$10B
60
*Fin HoldCos >$50B
40
Banks & S&Ls >$10B
20 SIFIs
0
Categories
Source: FFIEC, FDIC, Federal Reserve

14. Who‟s In the 2012-2013 Cycle?
CCAR 19

15. Who‟s In the 2012-2013 Cycle?
CapPR 11
Other US BHC‟s
>$50B in Assets

16. D-F/CCAR Stress Testing Cycle
November
October 1 January 5 March15
15
Fed & Banks Run Fed Runs Biggest
Public
Banks Scenarios Own Reporting
Banks‟
Develop Analyzes of Results
Scenarios Capital
Mid-
cycle
Process

17. Stress Test Creation
 Shocks to 26 (for 2012-2013) macroeconomic variables,
 Translated into impact on items of income and expense, and
 Flow those imacts through quarterly net income
 Add to forecast changes in the capital account to estimate
impact on regulatory capital
 Trading books subject to a separate, instantaneous shock

18. Macroeconomic Shocks
2013 Supervisory Scenarios 2012-2013
DJ Total Stock Market
20000
18000
16000
14000
12000
11042.3
10000
8000
7221.7
6000
4000
2000
0

19. From macro shocks to gains
and losses
 Crucial! Two ways to go:
implied relationship historical relationship
See, e.g., CCAR 2012: Methodology and Results for Stress Scenario
Projections, Appendix A

20. Market Shocks – Severe
Adverse - Equity
Equity by Geography
0%
-15%
New Zealand
Switzerland
United Kingdom
Sweden Chile
-30% Germany Mexico Philippines Turkey
Australia Euro Stoxx 50 Malaysia
India
United States 600 South AfricaIndex
FranceJapan
Stoxx Europe Poland South Korea MSCIMSCI World
China
Hong Kong
EAFE
Belgium
Finland
Canada MSCI All Country
-45% Denmark Hungary Taiwan Index
Netherlands Czech RepublicBrazil Indonesia IsraelWorld Index
Singapore
Greece (ACWI)
MSCI EM Index
Italy Argentina
Norway MSCI EMEA
-60%Austria MSCI EM Latin
Spain Index
America Index
-75% Bulgaria
Russia
Ireland
Portugal
Ukraine, -84.30%
-90%

21. Supervisory Scenario –
Market Shocks to FX Vol

22. ATM USDMXN Vol History
Supervisor Shock (vol pts)

23. Stress Testing under CCAR &
D-F
 The details
 9 quarter horizon, instantaneous shock for trading books
 As-of dates
 9/30 (and 3/31) for annual (mid-cycle) tests
 Random end-Q4 as-of date for trading books
 Implementation decisions
 Interpolation, extrapolation, proxying shocks
 Bank baseline scenario – adopt supervisory baseline?
 Models don‟t work with shocks
 Documentation
 Must use standard templates
 must document and justify deviations

24. Disclosure & Systemic
Risk Assessment

25. Disclosure under D-F
 From banks to the supervisor
 FR Y-14M (and 14A and 14Q)
 From the supervisor to the public
 Details of shocks
 Using both D-F and bank capital plan assumptions
 Worst quarterly and end-of-horizon capital ratios for severe
adverse scenario
 Using D-F capital plan assumptions
 Total 9 quarter net revenue and income, loan losses, trading
and counterparty credit losses

26. Disclosure under D-F
 From Banks to the public
 types of risks included;
 description of company scenarios (key variables, such as
GDP, unemployment rate, housing prices);
 description of the methodologies to estimate
losses, revenues, and changes in capital; and
 net revenue and income, pro forma capital and capital
ratios over the planning horizon.

27. Disclosure under Form PF
 Private Funds (SEC and CFTC regulated)
 Investment advisor or CTA/CPO
 >$150MM “regulatory assets” (or >$1.5 Billion
“large funds”)
 Reporting
 Large funds – 60 days after end of quarter
 Others – 120 days after end of year

28. Disclosure under Form PF
 May use internal methodologies
 Must not be inconsistent with instructions
 Must be consistent with internal/client information
 Do not net longs and shorts
 Value is notional amount (delta-adjusted)

29. Form PF – Stress Shocks –
Rates Yield in Pct.
Stress Tested US Yield Curve Using
SEC Form PF Shocks
4.5
4
3.5
3
2.5
2 Base Case (3, March 2013)
up 25bps
1.5
dn 25bps
1 up 75bps
0.5 dn 75bps
0
0 36 72 108 144 180 216 252 288 324 360
-0.5
-1
Months

30. Threats to Viability

31. Reverse Stress Testing
 Supervisory Guidance (SR 12-7)
 Financial HCos., Banks, S&Ls >$10 billion assets
 CEBS (GL32)
 FSA (CP 08/24, PS 09/20)

32. Reverse Stress Testing
 New concept for banks
 FSA (UK) leading in requiring this
 Regulators like it but are silent on method

33. Reverse Stress Testing
Defined
 “assume a known adverse outcome…
 “then deduce the types of events that could lead to
such an outcome.” (Federal Reserve Board SR 12-
7, p. 12)
 Sounds
simple, but…

34. Reverse Stress Testing History
FSA
FSA Proposed BIS Principles
Requirements US Supervisory
CRMPG III Rules for Sound UK banks go
Formalized Guidance
2008-08 (CP08/24) Stress Testing live 2011-12
(PS09/20) 2012-11
2008-12 2009-05
2010-12

35. Reverse Stress Testing
Illustration
Mirzai & Müller. 2013. On Reverse Stress Testing.
Intelligent Risk, 8-11.
 Pick critical loss level
(„CLL‟)
 Obtain 30K samples from
joint distribution of risk
factor returns
 Revalue portfolio 30K times
 Only look at those samples
where portfolio loss > CLL
By CaitlinJo [CC-BY-3.0
(http://creativecommons.org/licenses/by
/3.0)], via Wikimedia Commons

36. Reverse Stress Testing
Illustration
Mirzai & Müller. 2013. On Reverse Stress Testing.
Intelligent Risk, 8-11.
 Can we find economic meaning in
these large loss samples?
 First, look for statistical commonalities
using k-means clustering
 Second, relate cluster behavior to
market risk factors through heuristic
analysis

37. Reverse Stress Testing
Illustration
Mirzai & Müller. 2013. On Reverse Stress Testing.
Intelligent Risk, 8-11.

38. Reverse Stress Testing
In sum: immature art
Recent research collected at www.Gloria-
Mundi.com; search on keyword phrase
reverse stress.