Stress Testing – Ever heard of it?

Stress testing has not only been in the press recently, but the subject of many conversations the Lepus research team has been having with those in the industry on an ongoing basis. Risk is highly interdependent. It was not one risk factor that lies at the heart of the current economic crisis but a series of systemic risks that caught the global financial community off-guard.

Theoretically, stress testing should provide insight into capitalisation by modelling historic events as well as more hypothetical worse-case scenarios. However, in the real world, various banks and global regulators may have disparate and conflicting definitions of stress testing. Many of the worst affected institutions were not prepared for such sustained periods of illiquidity, as their simulation horizons had been far too short. Another problem that these banks experienced was the failure of senior management to fully appreciate the significance of the results of stress tests.

Both the UK and US regulatory bodies have announced separate plans to stress test banks with large capitalisation that may pose systemic risk. The UK, unlike the US, has chosen to keep the results of banks’ individual stress test scenarios secret as to not damage market stability.

If that insight into capitalisation is subject to interpretation, how can you trust the numbers coming out of stress tests? Depending on how you define stress tests how does it influence and relate to overall enterprise-wide risk management?

Keep a look out on our web site for answers to these questions in the coming months.

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Tagged with: 2009, blog, stress testing