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2. Approach to stress testing

As shown in Exhibit 3, most of the banks we interviewed currently have a simple stress-testing framework, but they recognize the need to move to a comprehensive approach. Typically, a central economic team develops scenarios for macro-economic stress; PD/LGD are stressed and used in economic capital decisions; and the stress-testing results have little to no impact on strategic decision making.

Exhibit 3

Current approaches to stress testing

2009 EC INTERVIEWS

Comprehensive

Advanced

Simple

Prevalence

Common

Common

Rare

Governance

  • Scenarios driven by central risk team

  • Ad-hoc involvement of leadership

  • Formal working group

  • Scenarios driven by central risk team

  • Formal working group

  • Scenarios driven jointly by

central risk team and BUs

Approach

  • Stresses based on statistical analysis of historical data

  • Stress includes:

    • Macroeconomic

scenarios

  • PD, LGD

Stresses based on statistical and fundamental analysis Stress includes: Macroeconomic scenarios PD, LGD, EAD Industry tests driven by BU risk teams Stresses based on statistical analysis of historical data Stress includes same as "advanced" plus PD/LGD correlations Systematic risk factor stress Ad hoc event shocks

Application

  • Economic capital

based on stress PD

  • Economic capital

  • Active portfolio management

  • Business exit/entry strategy

  • Pricing strategies

The Basel Committee on Banking Supervision recently released a new consultative paper recommending a comprehensive stress-testing methodology to complement existing VaR frameworks. Exhibit 4 on the following page summarizes these recommendations.

Incorporating best-practice stress testing will require banks to change their organizational structure and governance practices, conduct a broader range of tests, and incorporating stress-testing results into their decision making.

  • Organization and governance. Best-practice banks have a formal working group that defines and conducts stress tests, and individual business units play a significant role in identifying the key risks impacting their businesses and the relevant stresses across those risks. These banks also have an appropriate governance structure in place to oversee how the team functions.

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