By Mark Somers, Technical Director at 4Most Europe (www.4-most.co.uk)

Recent economic troubles in most major economies were made worse by the fact that major banks had not fully anticipated the scale of losses that were possible and therefore in many cases they were under-capitalised and under-prepared. The reason for this failure to understand the risks has many varied dimensions including inappropriate market incentives for banks, over-accommodating regulators, politicians with electoral incentives and geo-political transition changing the system in unexpected ways. Whatever the underlying reasons, what is key for banks and regulators, is to understand how to design a stress-testing regime that informs all stakeholders more effectively next time.

Banks are inherently good at managing risks they can quantify, for example interest rate hedging, daily market volatility or consumer credit cards. Where many fall short, is taking account of the risks that they know about but haven’t properly quantified, either because institutionally it falls into a gap or because they don’t understand the potential magnitude. Structures in the market that enabled banks to originate debt, package it and then move it off their balance sheets, often to other banks, were clearly broken. They had the legal trappings of risk transfer but across the economy leverage was increasing – and the ability to withstand shocks became wafer thin.

Time to ‘get serious’

Retail and commercial banks are clearly increasing their focus on stress-testing primarily in response to pressure from regulators. New regulations will require banks to disclose more information on the risks and capital consumption that they have quantified and this should enable investors and rating agencies to be able to come to a more informed decision for those elements.

However, the outputs still mainly inform the debates with regulators as opposed to linking effectively to risk appetite and ultimately business strategy. Stress-testing will have come of age when banks enter or leave lending to market segments and individual exposures within those segments based on insight as to what might happen in a downturn and how correlated this would be with the other exposures on the book.

Regulators are inevitably outgunned compared to the level of effort and insight the banks can put on the pitch regarding analysis of their own portfolios – as a result regulators can feel they are starting from a back foot. This leaves them in a difficult position – to concede ground and look for compromise with banks, typical of the regulatory approach in the run up to the crisis; or to stick to their guns, even though in some cases they may be wrong, and potentially be a constraint on the industry and ultimately the economy as a whole.

What is happening globally?

Internationally (including in the UK) banks are being asked to complete analysis to explain how their portfolios would react under defined regulatory scenarios and demonstrate the level of capital they would maintain in these stressed situations. These results are aggregated and anonymised by regulators and high level results have been published to instil confidence in the system overall.

Another exercise the banks are asked to complete is what is called a reverse stress test – essentially to answer the question: How bad would it have to get for the bank to fail?  One enhancement I believe could be made is rather than defining a single failure, scenario banks should be asked to provide the risk contours of key stress indicators, GDP, interest rates, unemployment etc. that it would take for the bank to fail. The regulator could then compile the super-position of these across all major different banks operating in a market to understand the conditions under which there is a likelihood of systemic failure. These results should be published to enable economists and rating agencies to understand clearly how safe the banking sector really is.

Regulators make waves

Another interesting outcome that has been adopted internationally is for regulators to have their own private stress-testing tools for comparison. In fact, regulators are building their own stress-testing tools in the UK right now. The issue for banks is that they don’t want to be a position where it is the regulator arguing for their model vs the bank for its own. Instead banks need to understand the range of models that are possible and consistent with their historical data. Then the question: Is the regulators result consistent with this range? And if not, what effect has the regulator failed to capture to evidence that the banks internal models are more reliable?

This and the idea of publishing stress-testing results should provide both the carrot and the stick to incentivise banks to take stress-testing seriously and act on it appropriately, even when conditions have been benign for an extended period, as was the position at the start of 2007.

Improving stress-testing capabilities

With this motivation banks can look to improve their stress-testing capabilities in a number of ways:

• Recognise that there is no one, best stress-testing model (as opposed to forecasting). Model risk is a key and assessing multiple approaches and assumptions in a systematic way is an important component in estimating uncertainty in losses.
• Build a stronger link between current provision calculation and future loss forecasts. Banks increasingly need to demonstrate they are fully providing for their forecast losses.
• Unpick possible structural changes in the book from economic changes outside. What would the loss profile do if the bank closed to new business? This could be a potential stress-test scenario but one that few purely statistical models can answer clearly.
• Understand the benefits of exploring a wider variety of stressed scenarios. Typically banks are asked by regulators to investigate a handful of outcomes, in reality any one of these has a vanishingly small chance of happening – how can banks demonstrate they have all the bases covered without fully exploring the multitude of potential scenarios.

If these can be tackled critically and the outcomes are fully embedded in the way the business is monitored and the actions it takes today, then next time it should be very different.

About 4most Europe (www.4-most.co.uk)

4most Europe Ltd is a specialist credit risk analytics consultancy with offices in London and Edinburgh. The company provides a range of products and services across credit risk, fraud and pricing, working with blue chip clients predominantly in the retail banking and mobile sectors. The company offers a flexible, competitive model, either working with clients to manage regulatory change or delivering and implementing business critical solutions.