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November 22, 2009
Macro StressTesting : The King has no clothes
Stress Testing is not a new agenda now. Rather it is a popular agenda with improper discussion and undue coverage on insignificant results. World Premier of “US Stress Test” attracted much lime light. It unduly focused on insufficient selection of two scenerios, only extending to 2010 and injudicious selection of only three macroeconomic factors. The obvious choice should have a full Monte Caro simulation of all risk factors for 20 years. This raises doubt about FSAP program’s objective, which unfortunately resembles a marketing Quick Win strategy. Further, accounting projections are required to be supplemented by MtM, which was never thought of. This shows that several black holes are plugging other black holes, which is risky and dangerous.
It is a matter of fact, post traumatic learning from the “financial tsunami” of the subprime mortgage crisis, the stress Testing has evolved as an integral part of the overall risk governance and risk management culture of the bank. Present credit crisis has necessitated taking liquidity risk into stress testing framework in addition to credit risk and others. The manifestation of liquidity risk can rapidly move the system into tail of loss distribution through bank runs. Further macroeconomic consequences of rating sensitive capital have proved that a procyclical consequence of minimum capital requirement is the order of the day. Failure of efficacy of many models in credit crisis has driven the agenda that stress test should complement complex risk management models. The outcome of the forward-looking stress testing will be dynamic in nature and would guide the bank how the plausible events would adversely impact the banks. This also gives rise to a comprehensive stress testing framework under Pillar II, which encompasses all risks, and this will be subjected to supervision of Central Banks and be incorporated in ICAAP framework. There is a migration from conventional micro models to macro models due to economic downturn. Specially there have long been dependence on macro economic variables like dependence of PDs (Probability of Default) on macroeconomic variables and dependence of exposure at default and collaterals on variables like interest rate which are partially macro.
Cobweb of Regulation : Banking on Basel
The Stress Testing is viewed by regulators as a key component of supervisory assessment process to identify the vulnerabilities and evaluate bank’s capital adequacy. However, the Stress Testing for Market risk a old phenomenon which is well elaborated in the book elsewhere. Later growing emphasis is given to Credit Stress Testing factoring the macroeconomic scenarios and later focus is on Pillar II stress Testing which takes into consideration of all risks including reputational risk. The Basel Committee on Banking Supervision has issued Principles for sound stress testing practices and supervision on May 2009 (Final Version) which put forth a comprehensive set of principles as guidance for the Banks.
The guidance sets for weaknesses that affected the performance of stress testing during the crisis which are broadly classified as follows:
• Use of stress testing and integration in risk governance
• Stress testing methodologies
• Scenario selection
• Stress testing of specific risks and products.
Under use of stress testing and integration in risk governance, BIS emphasized the appropriate use of stress testing in banks’ risk governance and capital planning. The business areas used to believe that the stress testing is not credible. This requires to be changed and an integrated framework rather than silo wise approach would be implemented. This would pave the way for an overreaching approach rather than mechanical approach.
Under stress testing methodologies, BIS emphasized the inclusion of the strong interlinkages like for example that exists between lack of market liquidity and funding liquidity pressure. There is a range of practices in stress testing from the simple sensitivity to complex stress testing. This also takes varying degrees of aggregation e.g. from a level of an individual instrument up to the institutional level. Though many cases, the historical relationship was used, the credit crisis has proved to be inefficient by underestimating the interaction between risks and the firm-wide impact of severe stress scenarios.
Under scenario selection, BIS emphasized on sophisticated scenario selection, which enables shocks to many parameters simultaneously. While scenarios could be either historical or hypothetical, the weakness found in historical ones in credit crisis is that it were not able to capture risks in new products which have driven the crisis. Furthermore,
Moderate Hypothetical Scenarios were considered as extreme or innovative were often regarded as implausible by the board and senior management.
Under Stress testing of specific risks and products, BIS stated that the following risks were not covered adequately are as follows:
• the behaviour of complex structured products under stressed liquidity conditions
• pipeline or securitisation risk
• basis risk in relation to hedging strategies
• counterparty credit risk
• contingent risks; and
• funding liquidity risk.
Amongst others, stress tests also assumed that markets in structured products would remain liquid or, if market liquidity would be impaired, that this would not be the case for a prolonged period. This also meant that banks underestimated the pipeline risk related to issuing new structured products.
In the midst of the Birth Pains: Macroeconomic Stress Testing Model
A macroeconomic stress testing model generates projections of macro variables as deviations from a base line scenario. The framework for macro stress testing will require the selection of extreme but plausible shocks. These can be univariate shocks in single risk factors or multivariate scenarios with various (macro) risk factors change. For example we may use a depreciation of the dollar exchange rate is combined with a falling GDP and rising interest rates. The scenarios can be developed through the stochastic simulations of macro variables.
The stress testing has shifted its focus mostly on macroeconomic models to factor into systematic shocks. The macroeconomic models are mostly classified into
(i) a structural econometric model
(ii) vector autoregressive methods, and
(iii) Pure statistical approaches.
The structural macroeconomic models are used to project the levels of key macroeconomic indicators under stress circumstances, where shocks are as exogenous inputs. For FSAP (i.e. ) exercise, the authorities applies the domestic macroeconomic models developed for monetary policy purposes. Vector Autoregression (VAR) or Vector Error Correction Model (VECM). A VAR model comprise of GDP, inflation rate, bank loans outstanding, effective exchange rate, and the overnight call rate. Another variant a Global Vector Autoregressive (GVAR) is modeled on country or region specific VECM. The VEM may be used to forecast the stressed EDFs. This model allows the joint shock of macroeconomic variables, which enables vector process to process the stress impact on the variables. A pure statistical model may allow macroeconomic and financial variables to be modeled through a multivariate t-copula.
Credit Stress Testing – A Practitioner’s Choice
Process 0.1 – Identifying a Stressed Case
Process 0.2 – Setting the objective
Process 0.3 – Assessing the fundamental drivers
Process 0.4 – Segmenting the portfolio
Process 0.5 – Identifying the stress factors (i.e. risk factors)Process 0.6 – Constructing actual scenarios
Process 0.7 – Incorporating model drivers into scenarios
Process 0.8 – Analyzing stress test output
New Avatar : Contingent Claim
Dale Gray and James P. Walsh in paper “Factor Model for Stress-Testing with a Contingent Claims Model of the Chilean Banking System “ (April 2008 IMF Working Paper No. 08/89) proposed risk indicators for the major Chilean banks based on contingent claims analysis, an extension of Black-Scholes-Merton option-pricing theory. These risk indicators are clearly tied to macroeconomic and financial developments in Chile and outside, but bank responses are highly heterogeneous. To reduce the number of variables linked to the banks' risk to a tractable number, they applied principal component analysis. Vector autoregressions of risk indicators with the most significant factors showed strong ties from financial markets and regional developments.
The stress test was not stressful enough
For Macroeconomic Stress Testing, one of the keys will be how Bank conducts stress tests determining how future minimum requirements could potentially increase under Internal Ratings Based Approach under Basel II. My worries how stressful will be these stress tests based on specific deterministic macro scenarios prescribed by the regulators.This remains an open question, unclothed.
Posted by ddutta7 at November 22, 2009 12:30 AM
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