Regulatory guidance of Stress testing has remained rather scanty, with much of the guidance coming from UK, European countries and Australia. India and Pakistan has also issued stress test circulars.
The Basel guidance in this respect is rather subjective. Overall,there is less clarity on how to conduct a stress test . Also, supervisors are far from convinced about the interpretation of stress test results and regulatory action based on the results of the stress tests.
Take the US case for instance. The SCAP guidance was issued on April 24,2009 and within two weeks the stress tests were conducted on 19 banks by 150 supervisory personnel from FED. The speed with which this was conducted is indeed praiseworthy. One is however less certain about the quality of the underlying models and it is be seen whether the models could withstand the test of time. At the same time,debates were sparked off in the interpretation of the results
The results in the US were significant indeed and deserved a debate. Out of nation's 19 top banks. the results indicate that ten need to boost their capital levels and the combined additional capital requirement is USD 75 billion. In the stress test results release, the Fed's analysts report their estimates of losses and loss rates across bank exposures, resources available to absorb those losses, and the resulting necessary additions to capital buffers. The estimates reported by the Federal Reserve represent hypothetical "what-if" scenario for adverse market and ecoinomic conditions. Bank of America Corp needs to raise USD 33.9bn dollars in extra capital. That could force the bank to make the government a major stakeholder in exchange for extra support. Other top banks that will be asked to raise more money: Citigroup Inc needs USD 5.5b, Wells Fargo & Co needs USD 13.7b, and Morgan Stanley must find USD 1.8b. GMAC LLC, the former financing arm of ailing carmaker General Motors Corp, must raise USD 11.5 b. Major banks including JPMorgan Chase & Co, Goldman Sachs Group Inc and American Express Co passed the stress tests.
The interpretation of stress tests raise certain questions:
Are we focusing too much on capital?
In stress tests, the results are driven both by exposures and capital levels. Capital is not seen in isolation, but in relation to capital. If the business strategy is not right, no matter how much money you have in the purse, it may eventually turn out to be inadequate. Tweaking the business plan, setting a limit on how much risk a bank is willing to take becomes as important as having capital in the kitty. Just giving a figure of capital requirement is not enough, stress tests should be forward looking to suggest ways to de-stress the portfolio through a well- balanced view of business strategy and capitalisation.
Business strategy and De -Stressing the Portfolio
The alternative to capital infusion is changing the business strategy. Banks can be given the opportunity to de-stress their portfolio.instead of immediately raising capital in a costly manner. Over-emphasis on capital will ultimately affect business performance. Adjustments in business strategy, coupled with strategic infusion capital should ideally follow a stress test. A repeat stress test after a few months, may be the right approach to look at the effectiveness of stragic realignment of business needs and capital adequacy.
While the SCAP report talks about business mix, it still appears strongly focussed on capital as the currency of risk. Risk management and business strategy must come closer and effectively interact to tackle an uncertain world, and stress tests may be the ideal medium to convey this messege to the top management.
And the regulators who are managing the show to a great extent.
