Enhancing Operational Performance while Building Confidence: The Case for Stress Testing

1. Presented by Kevin Greenidge (CBB) & Jide Lewis (BOJ) CAIB 37th Annual Conference "Repositioning the Region: The Role of the Financial Services Industry" 11 November 2010 Enhancing Operational Performance while Building Confidence: The Case for Stress Testing

2. OVERVIEW 1. Lessons from financial crises. 2. What is stress testing? • Stress Testing at the level of the individual FI –Guideline • Stress Testing at the System level

3. Lessons from financial crises • Insufficient consideration of extreme events • “It is hard for us without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions.” August 2007, Joseph Cassano, a former AIG executive • “Almost no one expected what was coming. It’s not fair to blame us for not predicting the unthinkable.” Daniel Mudd, former chief executive of Fannie

4. What is stress testing? • Stress Testing: Risk management technique used to evaluate the potential effects on an institution’s financial condition, of a set of specified changes in risk factors, corresponding to exceptional but plausible events. • It is a rough estimate of how the value of a portfolio changes not a precise tool that can be used with scientific accuracy. • Originally developed for use at the portfolio level, to understand the latent risks to a trading book from extreme movements in market prices. • Now applied a broader context, with the aim of measuring the sensitivity of the entire financial system to common shocks

5. What is stress testing? • Stress testing the entire financial system has several important differences with portfolio-level stress tests. • First, the ultimate intent of focusing on the system as a whole is to identify common vulnerabilities across institutions that could undermine the overall stability of the financial system. • Second, it is more macroeconomic in nature, as we are interested in understanding how major changes in the economic environment may affect the financial system. • Third, there is a difference in the complexity and degree of aggregation. • System-focus tests involve aggregation or comparison of more heterogeneous portfolios, -apples & orange problem.

6. What is stress testing? • System focused stress tests should complement the regular stress testing done by individual financial institutions. • They are designed to complement them with a broader understanding of the sensitivity of the overall system to a variety of shocks, and to leverage the existing expertise found in different institutions. • Stress testing at the level of the financial system can be done one of two ways: • simultaneous stress tests of multiple portfolios using a common scenario, or • a single scenario applied to an aggregated portfolio or model of the entire system.

7. What is stress testing? • Sensitivity Test: Form of stress testing which typically involves an incremental change in a risk factor to determine the impact on an insurer • Scenario Testing: Form of stress testing which uses a hypothetical future state of the world to define the changes in the risk factors affecting the insurer.

8. Here is what we hear happened at Lehman

9. Weakness in Bank Stress Testing – Pre-Crisis

10. Stress Testing at the level of the individual FI –Guideline • Broad purpose of stress testing • Stress testing should be embedded in enterprise wide risk management • It should be actionable, playing an important role in development of risk mitigation or contingency plans • It should feed into the institution’s decision making process (e.g. setting risk appetite, exposure limits, and evaluating strategic choices) • Stress testing should be clearly documented & available for review

11. Stress Testing at the level of the individual FI –Guideline • Specific purposes of stress testing • Risk identification and control • Complementary perspective to other RM tools • Supporting capital management • Improving liquidity management • Role of the Board and senior management • Board has ultimate responsibility for the overall stress testing program and that it is “fit for purpose” • Senior management is accountable for the program’s implementation, management and oversight.

12. Stress Testing at the level of the individual FI –Guideline • General considerations • Stress testing should take account of views from across the organisation and cover a range of perspectives and techniques • Written policies and procedures governing the stress testing program - Appropriate operating documentation • Robust and flexible infrastructure for changing stress tests • Regular and independent assessment • Methodology and scenario selection • Deliver a complete picture of institution-wide risk • Cover range of scenarios, including non-historical scenarios, and take into account system-wide interactions and feedback effects • Include range of severities, including events capable of generating the most damage (e.g. size of loss or reputation) - determine what scenarios could challenge viability of institution (reverse stress tests)

13. Stress Testing at the System level • Best seen as a process consisting of five stages: • identification of specific vulnerabilities or areas of concern, • construction of a scenario in the context of a consistent macroeconomic framework. • map the outputs of the scenario into a form that is usable for an analysis of financial institutions’ balance sheets and income statements, • performing the numerical analysis, considering any second round effects, • summarizing and interpreting the results. • Each stage of the process is important to understanding the sensitivity of a financial system to a particular shock or vulnerability.

14. Stress Testing at the System level • Stage1: Identifying Vulnerabilities: • we try identify the main vulnerabilities facing the system. • It is important to keep the focus narrow; • Concentrate on weak points in a financial system • enables us to tailor the stress testing exercise more effectively, and • permits a richer understanding of inherent vulnerabilities, and a • more effective use of time and resources.

15. Stress Testing at the System level • Stage1: Identifying Vulnerabilities: • we try identify the main vulnerabilities facing the system. • It is important to keep the focus narrow; concentrate on weak points in a financial system • enables us to tailor the stress testing exercise more effectively, and • permits a richer understanding of inherent vulnerabilities, and a • more effective use of time and resources. • We also make use of a range of numerical indicators to help isolate potential weaknesses, • macro-level indicators, • broad structural indicators, • Ownership and Market structure • Balance sheet structures • and institution-focused or micro-level indicators (FSIs).

16. Stress Testing at the System level

17. Stress Testing at the System level

18. Stress Testing at the System level • Stage 2: Construct a scenario: • Once the key questions or main vulnerabilities of interest have been identified, the next stage is to construct a scenario that will form the basis of the stress test. • It is recommended that some macroeconomic framework or model be employed. • The objective of using an explicit macroeconomic model is to link a particular set of shocks to key macro and financial variables in a consistent and forward-looking framework. • The key reason for using this approach is to bring the discipline and consistency of an empirically-based model and an explicit focus on the link between the macroeconomy and the main vulnerabilities.

19. Stress Testing at the System level • Stage 2: Construct a scenario:

20. Stress Testing at the System level • Balance-Sheet Implementation: • the next step is to translate the various outputs into the balance sheets and income statements of financial institutions. There are two main approaches to translating or “mapping” scenarios into balance sheets: • the “bottom-up” approach, where estimates are based on data for individual portfolios, which can then be aggregated, and • the “top-down” approach, which uses aggregated or macro-level data to estimate the impact.

21. Stress Testing at the System level • Balance-Sheet Implementation:

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