Deloitte Touche Tohmatsu LLC Tsuyoshi Oyama

1. Stress Testing: An Approach to Making Forward-looking and Objective Scenarios Deloitte Touche TohmatsuLLC Tsuyoshi Oyama This paper does not include the official view of Deloitte Touche Tohmatsu LLC but only reflects the lecturer’s own opinion.

2. Required elements Deep involvement of board and senior management Clarification of degree of stresses Transparent and accountable process of stress testing Forward-looking scenarios Objective scenarios Dynamic scenarios Comprehensive scenarios based on root causes Use of the outcome of stress testing for business strategy as well as risk management Flexible update corresponding to changes in external environments Post-crisis Stress Testing -- Required Elements

3. (Step 1) Scenario conditions 1.1 Determine the degree of stresses (severity and frequency) to be assumed in stress scenarios in line with risk appetite of senior managers 1.2 Identify all important risk factors for own portfolio and pay higher attention to the scenarios that could impact them significantly (Step 2) Prepare the tools to make forward-looking scenarios 2.1 Make several enterprise-wide forward-looking stress scenarios using, for example, the following tools Several early warning indictors of banking crisis to select the scenarios The future event database that controls the flood of information of emerging stress events from international/national agencies, media, academics, etc. on timely manner The stress event database that comprises big stress events in the past, of which causes and root causes are analyzed and categorized for supporting the scenario-making Global macro economic modeling techniques that forecast the development of macro-economies of major countries under the certain scenarios over the coming 2-3 years A Way of Making Stress Scenarios 1/2

4. (Step 3) Determining forward-looking stress events 3.1 Confirm the countries with high probability of banking crisis using the early warning indicator 3.2 List up 4—5 stress scenarios highlighted by the market, regulators, media and academics using the future event database and the information of 3.1 and 3.2 3.3 Narrow down the number of stress scenarios by using the conditions identified by Step 1 3.4 Determine the severities and frequencies of stress scenarios based on the risk appetite confirmed by Step 1 (Step 4) Narrating the stress scenario stories 4.1 Make the stories of stress scenarios using the stress event database 4.2 Determining the paths of macro-economic indicators of major countries over the coming 2-3 years under the stress scenarios using the global macro-economic modeling techniques (Step 5) Translating the macro stress scenarios into risk parameter 5.1 Translate macroeconomic indicators assumed under the stress scenarios into risk parameters 5.2 Identify the impacts of stress scenarios on FIs’ portfolios A Way of Making Stress Scenarios 2/2

5. Example 1 Early Warning Indicators • This tool is expected to enhance forward-looking, objective and macro-oriented scenarios The case of early warning indicators of financial crisis occurring in a major country • International and national agencies, as well as academics have already developed various early warning indicators relating to financial crisis, which will be used • These indicators Identify the region(s) with probability of crisis occurring above a certain threshold

6. Example 2 Global Risk Heat Map based on the Future Event Database • This tool is expected to enhance forward-looking, objective, comprehensive and macro-oriented scenarios Changes in future event heat map (From August to September 2010) • Scenario 1: US economy double dip recession ⇒probability increases • Scenario 2: Euro crisis ⇒a little moderated • Scenario 3: China bubble bursting ⇒no change • Scenario 4: JGB bubble bursting ⇒no change • New scenario? ⇒Basel III shock scenario SAMPLE

7. Example 3 Stress Event Database 1/2 • This tool is expected to enhance objective, dynamic and macro scenarios • There were so many financial and economic crises in the past • While the same event with the past could not occur, the events having similar elements with the past tend to occur repeatedly

8. Example 3 Stress Event Database 2/2 • The trigger event, cause and root cause of each event are analyzed and classified into several categories so as to facilitate the process of making the scenarios with a modern combination of some elements of past crises SAMPLE Stress event DB structure

9. Example 4 Macroeconomic modeling • This tool is expected to enhance objective, dynamic and macro-oriented scenarios SAMPLE Baseline/Japan Stress/Japan Baseline/US Stress/US

10. Example 5 Stresses associated with market micro structure • This tool is expected to enhance objective and micro-structure based scenarios Macro Fundamental Macroeconomic Causes Market Micro-structure Typical factors behind historical huge losses of investment banks Unexpectedly immobilized position Market Crash Market liquidity evaporation Delayed recognition of market position Unexpected correlation Huge losses Market instability Market Micro-structure Fund-raising problem Micro

11. Example 6 Translation of the development of macro economic variables under the stress scenarios into risk parameters Estimating the effects of macro economic change on credit cost and credit risk: PD case Specification of the relationship between economic cycle/GDP growth rate and PD by industry Specific hypothesis in accordance with shock scenario (e.g., double the PD for lowly rated bonds, setting PD=100% for top X% of major client) Parameter Approach Some examples First confirming the state dependency of rating migration and then applying the rating migration under economic downturn First estimating the relationship between credit scores and macro economic variables and then using the result to calculate PD under the stress scenario First estimating the sensitivity of financial data of major obligors to main macro economic variables and then using this information to estimate the financial state of these obligors under the stress scenario 【Concepts of PIT and TTC】