A recent Executive Summary, sponsored by OpenLink is the white paper ”Credit Meltdown Recovery? Harnessing Stress Testing for Effective Risk Control”. It highlights several key trends surrounding stress testing, including the need for a defined stress testing regime and a firm wide, cross asset class risk management solution.

Introduction

The events of the past 18 months highlighted the need for banks to be more aware of the systemic risks to which they are exposed. In the wake of the credit crisis, stress testing has emerged as the tool of choice when assessing the impact of low probability, high impact events. There has been a substantial increase in regulatory demands for firm-wide stress testing as supervisory bodies worldwide decide how best to prevent future liquidity and credit crises from occurring. 

The key factor driving the use of stress testing is pressure from regulators. Supervisory authorities such as the FSA, SEC and BIS all cite stress testing as a fundamental part of the risk management framework. Most notably, the FSA has published a number of consultative papers under the title ‘Strengthening Liquidity Standards’ that focus on the use of stress testing and scenario analysis.

Key Findings and Recommendations

In a Lepus conducted research study where financial institution executives were interviewed to determine what actions are being taken to prevent future liquidity and credit crisis, it was recommended that:

• A Stress Testing Regime Be Defined – Research indicates that many banks feel that traditional historical scenarios used in stress testing have been somewhat discredited as a result of the crisis. Banks should now try to use more forward-looking hypothetical scenarios that simulate a possible future event. There has also been an increased use of ad hoc stress tests to assess the impact of certain risk factors.
• Stress Testing Should Be Implemented Organization Wide – One of the positives to emerge from the credit crisis is the increased profile of risk management. While the results of stress tests would once have been largely discarded by financial institutions, they now command far greater attention. To make the most of the stress testing process, results should be used widely across the bank. There is an increasing trend for senior management to use results as an influence on strategic business decisions. 
• A Firm-Wide, Cross Asset Class Risk Management Solution Should Be Implemented – The benefits of a firm-wide and cross asset class approach to risk management are substantial. Further to giving banks the ability to manage risk across all global entities, it can also greatly reduce the burden of regulatory reporting.

Conclusion

Regulatory pressures look certain to drive banks toward a more comprehensive, firm-wide approach to risk management. Over the coming months banks will make significant investment in their stress testing platforms to bring them in line with regulatory demand. Although historical scenarios are now deemed less credible due to the events of the past 18 months, hypothetical economic disasters and ad hoc stress tests are being used with increasing frequency. The renewed interest in stress testing from senior management will ensure that it receives the necessary support and investment to produce an accurate and useful assessment of exposure across the organisation.

Used effectively, firm-wide stress testing will become an essential tool that banks use not only to manage risk, but also as a driver of future strategic business decisions.

To receive a free copy of this report, please send your name, job title, address and phone number to marketing@lepus.com and we will ask the sponsors of the report to email a copy to you.

Tagged with: 2009, Executive Summary, risk, risk management, stress testing