Stress testing involves analyzing how financial institutions would cope with extreme economic scenarios to test the resilience of their capital and liquidity positions. Regulators now require more comprehensive stress testing that examines how individual institutions and the entire financial system would respond to market-wide crises. Banks must model their liquidity buffers under idiosyncratic and market-wide stress scenarios. This new regime will improve risk management but also presents significant data, systems and management challenges for banks to integrate stress testing into their existing processes and risk models.

1. Stress Testing
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2. Introduction • little consideration was given to system-wide
One of the major outcomes of the Credit Crunch outcomes of tests and particularly the adverse
has been that banks, regulators and the whole effects that could arise from the behaviour of
financial market have had to question the validity other firms in markets or via the real economy
and even usefulness of some standard risk in response to those stresses.
management systems. Why was it that so many In addition standards were observed to be
institutions were overextended in the credit below acceptable practice, with some institutions
boom up until the summer of 2007 and why having insufficient holdings of liquid assets.
weren’t risk controls flashing appropriate In addition the age old problem, of banks
warning signs? Given that very few early cutting corners by funding their portfolios of
warning signals were triggered, what can be illiquid asset with short-term liabilities. And
done to improve our risk management systems equally important far too many institutions had
in the future? insufficient detailed information in their cash-flow
projections and frequently lacked rigorous liquidity
This state of affairs has caused regulators, often
contingency plans.
pressed by politicians who have had to calm
voters concerns, to look for additional new Now it is all change – over the past year
approaches for measuring and managing the regulators have devised a much more
financial risk. Clearly there is no magic bullet comprehensive regime – will it work? For bank
that can warn for every eventuality but equally treasurers this new stress testing regime really
relying on ever more sophisticated manipulation means liquidity risk (though of course it can
of data from the past doesn’t always seem to equally be deployed to assess credit exposures,
work. One area that almost immediately attracted market risk and operational risk). What are the
the regulators was increasing the use of stress challenges? How can the best approaches be
testing – this in many ways is not a new idea employed, what new skills are needed, will there
but perhaps more sophisticated approaches be software requirements and what exactly do
could be used to plug some of the gaps in the the regulators expect?
existing risk systems? Certainly the Turner Liquidity Risk Drivers
Review (which examined the causes of the credit
Starting with regulatory demands, the key change
crunch, the impact on the financial sector and
has been to identify ten Liquidity Risk Drivers,
possible remedies for the future) in London took
and critically banks have to demonstrate how
this view and this has been embraced by the
these are incorporated into two specific types of
major regulators around the globe. Whilst some
scenario; these being the idiosyncratic scenario
stress testing had been conducted in the past
plans and the market wide scenario plans. The
it had been rather limited in its scope and
idiosyncratic plans test for a liquidity event at
had clearly not helped in identifying problems
the individual institution, and the market wide
for many major banks during the unfolding
plan is to see how an overall market event
credit crisis.
would impact an institution’s liquidity. The idea is
To quote the FSA in London (whose thinking is in that from these scenarios banks can model their
line with the major regulators) liquidity buffers and then have to demonstrate
that such buffers are in place and meet the
Deficient stress testing was identified as one of the
continuous requirements regarding their liquidity,
failures that contributed to the current financial
and credit worthiness (in broad terms these
crisis in the following ways:
buffers have to be cash, balances at central
• Firms devoted insufficient resources to stress banks and government securities issued by
testing before the crisis; major countries as listed by the regulators).
• Firms and regulators failed to test against These plans also come with both quantitive and
sufficiently extreme macroeconomic qualitive assessments. Naturally enough the
outcomes; and former is well suited for developing appropriate
Stress Testing

3. software but the latter takes banks into the • External funding sources will have to be
possibly unfamiliar territory of scenario planning. continuously available to all the bank’s
Here judgements and methodologies are much internal risk and pricing applications.
more fluid and a different management approach
is needed. This will need new skills for many
bankers – and it may well be that staff are All of this means that connectivity to markets
recruited from other sectors (e.g. the Oil where the assets in question are traded or valued
Industry, Chemicals and Pharmaceuticals) where is even more critical than currently. Pricing and
such planning techniques are well understood valuation data has to be captured and updated
and established. on a continuous basis – and across what may be
a plethora of existing legacy systems. Of course
There are also spin off business effects from much of this work is already done, but now it will
this new liquidity framework. With a much closer be under very intense scrutiny with the threat of
focus on liquidity and crucially its true cost, punishing restrictions and controls imposed by
there will now be strong incentives for firms regulators if they feel a bank has not done its
to correctly price liquidity across business homework properly.
units. This will help strengthen the commercial Finally the real issue surrounding stress testing
viability of many firms as previously profitable is not just about data, systems and accurate
transactions and positions may be rather less liquidity provision and pricing – it is about senior
attractive when liquidity costs are truly accounted management’s ability to create and control the
for – so weaker deals are more likely to be rejected. complex systems required. This is no mean
undertaking – the challenges range from new
Another area that this regime will shed light on
specialist systems and IT upgrades, through to
is the often complex liquidity issues regarding
even better data and also how to blend in the
cross border relationships within firms, the
“soft” tools such as scenario planning and
regulators now expect stress tests to examine
reverse stress testing routines.
any effects of poor liquidity across borders and
jurisdictions. This has been shown by the Future Challenges
collapse of Lehman Brothers to be an area full
of potential problems, some of which could Clearly the advent of more sophisticated stress
prove disastrous if proper liquidity buffers and testing is a positive step – here are some of the
contingencies are not in place. major challenges and issues that could well
emerge in this area in the future:
Action Time for Banks
All of the above generates a huge amount of • Stress testing is not the new panacea and
work for the banks; consider the following issues has to be used in careful conjunction with
firms will need data and systems for: other tools. The key message is that stress
• Calculating the cost of funding across testing (and the so called reverse method)
different markets, aggregating the data and are complements to existing tools. It
integrating internal systems to correctly also presupposes a great deal of data
apportion those costs. integration across multiple locations and
• Accurate and timely data to create correct timeframes – these are significant business
risk-adjusted valuations for balance sheet and IT challenges.
items – and to be able to calculate liquidity
buffers on a continuous basis. • However “reverse” stress testing may prove
to be a disappointment to regulators – it is
• Banks will have to be able to monitor hard to believe institutions will devote more
accurately their cost of capital over multiple than the minimum regulatory requirement on
time periods. planning their own funeral.
Stress Testing

4. • It is easy to make bad mistakes in scenario Further Reading
planning – care and the use of tried and
tested methods from other industries will For those interested in understanding how the
be needed. It may well be that financial wider topics of futures planning and scenarios
institutions (and perhaps the regulators) are conducted in other industries take a look at:
will need to draw on planning talent from The Art of the Long View – Planning for the Future
entirely new sectors so that they get the most in an Uncertain World by Peter Schwartz
from the process.
The Living Company by Arie de Gues
• Stress Testing is not just another compliance
issue – if managed correctly it can help
improve the business going forward. It is
also not a one off exercise – building a
dynamic and continuous scenario planning
process is the secret to getting the most
from the process.
Stress Testing