STRESS TESTING Implementation & Application

(1)

Instructor: Dr. Khoo Guan Seng

Adj. Prof., School of Business, Singapore Management University Chief Representative, US *Academy for Business & Financial Services

*[Authorized ABA (American Bankers Association) Certification Provider]

STRESS TESTING STRESS TESTING

Implementation & Application

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1. Introduction and backdrop 2. Review of key risk measures

3. What is stress testing? - Definition

4. Why stress testing (Supervisory & banks’ expectations) 5. Stress Test - External Drivers

6. Stress Test - Internal Drivers 7. Types of Risk Factors

8. Categories of Stress Tests 9. Sound & Best Practices

Stress Testing Decision Sequence

10. Implementation challenges Examples/Illustrations

Q&A

Agenda Today

Agenda Today (sessions 1&2) (sessions 1&2)

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KL-Revised Presentation Slides for

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Agenda

Agenda – – Session 2 Session 2

A Roadmap to Designing a Stress Testing Model

Credit Risk Stress Testing

The ABC of Stress Testing

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1. Introduction and Backdrop

Basel Proposal

(5)

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Minimum Capital Requirement

Three Basic Pillars Three Basic Pillars

Supervisory Review Process

Market Discipline Requirements

1. 1. Introduction & Backdrop Introduction & Backdrop

~ Basle Proposal

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The 3 Pillars & Stress Testing The 3 Pillars & Stress Testing

Minimum Capital Requirement

Minimum requirements provide economic incentives - in the form of lower capital charges*

*For those banks that develop better measures for their exposures to risk and better techniques for managing their risks

Hence, banks perform back-tests on their risk models to ensure they are valid and measure risk exposures appropriately

Pillar 1 Pillar 1

Generate capital Generate capital

requirements

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Supervisory Review Process

Pillar 2 Pillar 2

Supervisors evaluate how bank performs internal processes for risk management

Supervisors check that parameters and conditions used to evaluate risk measures are sound and rigorous – How?

One such tool/approach:

Outcome of Stress Testing Outcome of Stress Testing

The 3 Pillars & Stress Testing

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Market Discipline Requirements

Pillar 3 Pillar 3

The third pillar seeks to leverage the

ability of markets to provide discipline to banks to ensure that they are not holding unrealistically low levels of capital

Hence, banks perform stress tests to ensure banks’ capital adequacy in times of shocks

Enhanced market Enhanced market

transparency & reputation transparency & reputation

The 3 Pillars & Stress Testing

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From Pillar 1 to 3 From Pillar 1 to 3

Risk management process

Basle document (Jan ’96) – spells out stress testing as one of the prerequisites for internal model approval

Capital viewed as the last line of defense in a bank.

When risk management is insufficient, when reserves are exhausted, capital absorbs losses to prevent a bank’s failure.

But when capital runs out, the bank may become

insolvent, leaving public authorities and taxpayers

responsible for restoring depositors’ savings

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From Pillar 1 to 3 From Pillar 1 to 3

The challenge is determining how much capital is sufficient

Stress testing is considered to be an effective and necessary tool that complements statistical models for quantifying & monitoring risk and

capital adequacy

By its very nature, stress testing also sets a

high qualitative and quantitative standard for

risk management

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Digression Digression

2. Credibility: A racing car’s credibility is based on its

product reliability to withstand long usage and not to break down under extreme

conditions 2. Credibility: A Bank’s credibility

is based on its service, reliability and strength to ensure sustainability

1. Race-Car Driver: Do you prefer to drive a car with a reliable brand or a no-name car?

1. Customer: Do you prefer to do business with a known,

credible bank or a new unknown one? Why?

Formula 1

race car functions Bank Functions

Stress Testing is Not Unique!

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4. Quality Control II:

Supervisors check that

parameters and conditions used to evaluate car

performance are sound and rigorous

4. Pillar II: Supervisors evaluate how bank performs internal processes for risk

management

3. Quality Control I: Driver

performs driving tests over several laps on racing circuit under rain & shine for a few days to ensure it’s still in working order and not become defective

3. Pillar I: Bank performs back- test on their risk models to ensure they are valid and measure risk exposures appropriately - 1

^st

Pillar

Formula 1

race car functions

Bank Functions

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5. QC III (More stringent):

Racing car company &

“dummy” driver perform crash tests (stress tests)

to make sure car can withstand wide variations

in forces on impact, and still protect the driver 5. Pillar III (More stringent):

Bank performs stress tests to ensure bank’s capital

adequacy in times of shocks – 3 ^rd Pillar

Formula 1

race car functions

Bank Functions

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3. What is Stress Testing?

In Banking

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3. 3. What is Stress Testing? What is Stress Testing?

(in banking) (in banking)

Stress testing refers to

“the analytical process involved in subjecting a bank’s portfolio to a series of battery of tests, designed to study the performance of the bank’s portfolio under extreme adverse conditions to generate the potential risk

measures under plausible events in abnormal markets”.

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Definition Definition

Key Points Key Points

Series of Battery of Tests

More than 1 test or set of results

Extreme Conditions

Degree of severity critical

Plausible Events in Abnormal Markets

Unexpected and could have happened to competitors or in other countries

Paradigm shift in global financial markets

Historical (local) worst case

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4. Why Stress Testing?

Supervisory

&

Banks’ Expectations

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4. 4. Why Stress Testing? Why Stress Testing?

(Supervisory & Banks

(Supervisory & Banks ’ ’ Expectations) Expectations)

What does the bank hope to achieve?

Identify where the risk concentrations are?

Understand impact on bank if biggest customers default?

Impact on bank if historical worst-case scenario recur?

Impact on bank if it is hit by a similar severe credit loss event that affected competitors in the past?

etc…..

What does the regulator hope to achieve?

Able to understand mechanism through which stress develops Able to implement measures when the effects of stress events evolve into a vicious circle involving the real

economy, financial markets and the banking sector

etc……

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Other Considerations Other Considerations

Why?

Economic downturns always follow buoyant periods and economic

expansions

Unknown issue is when, the severity and scale of the economic recession

Can’t afford to be complacent

Proof of certainty of global recession

next slide

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U.S. Yield Curve Inverts Before Last Five Recessions U.S. Yield Curve Inverts Before Last Five Recessions

(5- (5 - year Treasury bond year Treasury bond - - 3 3 - - month Treasury bill) month Treasury bill)

-6 -4 -2 0 2 4 6 8

ar-69

ar-71

ar-73

ar-75

ar-77

ar-79

ar-81

ar-83

ar-85

ar-87

ar-89

ar-91

ar-93

ar-95

ar-97

ar-99

ar-01

% GDP Growth/

Yield Curve

% Real annual GDP growth

Yield curve

?

Recession

Correct 2 Recessions Correct

Recession Correct

Recession Correct Recession

Correct

Data though 12/5/00

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“ “ Stress Stress ” ” Events Occur Anytime, Events Occur Anytime, Sometimes Unexpectedly!

Sometimes Unexpectedly!

Negative Macroeconomic Environment

Oil crisis, high exchange rate, large current account deficit, etc.

Political & Social Instability

Bali bombing, SARS outbreak, general election, etc.

Impact of world’s largest market, US

Enron, dotcom bust, post-Sept. 11, etc.

Lack of Market Transparency

Analyst & IPO scandal, Unexpected risk from impact of insider trading, opaque corporate governance, etc.

Post-Irrational Exuberance

Fear & investor panic leading to short-term funds outflow after bubble

burst

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5. & 6.

Stress Testing Drivers

External Drivers

&

Internal Drivers

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5. 5. External Drivers External Drivers

To comply with Basle & IMF-FSAP recommendations

Basle Accord states that banks that use internal models to measure market (credit, operational) risk must conduct stress tests – requisite for model approval

Global Dependence of SE Asian nations

Still susceptible to short-term fund inflows & outflows

New Players on the Block: China & India ^(they

weren’t a factor in the past!)

Countries have to move up the value chain as traditional bases for manufacturing are shifting to China

Rise of business process outsourcing (BPO) esp. to India

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6. 6. Internal Drivers Internal Drivers

Reasons for banks:

Make risks more transparent by estimating potential losses on a portfolio in abnormal markets – Pillar 3 – enhances market transparency & reputation

Complement statistical models with information about losses under extreme events.

To comply with central bank requirements and recommendations, which typically follow the BIS guidelines

Reasons for supervisors:

To measure systemic risks

To understand tests undertaken by banks and ensure

adequate risk management

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Issues to Think About Issues to Think About

Trials & Pitfalls of Consumer Lending Trials & Pitfalls of Consumer Lending

Consumer lending seen to be the next frontier of growth &

hence aggressive lending

From corporate to SME to consumer

Quite a no. of credit products for consumers are of the unsecured type, e.g., credit card

Consumer credit scoring model relatively untested during bad times

During recessionary times, untested credit score models can

lead to NPL

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7. Key Elements of a Stress Testing Process

Background Understanding

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7. 7. Key Elements of a Stress Testing Key Elements of a Stress Testing Process

Process

Background Understanding

Majority of banks’ failures: Credit Risk

Recession cycle: typically 2 years or more

Default likelihood of counterparties or obligors: usually not within the 1

^st

year of getting the loan

Before embarking on stress testing, what are the lessons?

Data history

NPL, PD & LGD definitely increase in recessionary times Consider stress testing at every stage of credit risk

management process, including credit assessment &

application stage (e.g. credit scoring), etc.

Don’t neglect market & operational risks aspects

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Key Elements Key Elements ( ( Assumptions) Assumptions)

1. “Infrastructure” readiness:

Sufficiency & types of data to cover good & bad times MIS & Data-warehouse capability

Expertise (in-house or external)

2. Scenario selection & appropriateness (The 3 “Rs”):

Relevance: Europe-centric events (Euro crisis) may not apply in Asia

Realistic: Hypothetical Scenarios should be plausible in local context, e.g., LTCM-type loss events may not be applicable to some Asian markets

Reliable & Readily Available Database: The Scenario

chosen should be one where the institution is able to

collate and analyze the data pertaining to it

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Ensure Reliable Data

Survey Portfolio & Environment

Identify Risk Factors

Construct Stress Tests

Calculate Stress Loss Report Results

Take Corrective Action, if required

Reassess Stress tests for appropriateness

Does the Bank possess quantitative risk measurement

systems?

Yes No

Run Stress-tests using counterparty & portfolio

risk models

Estimate bottomline of counterparties under

stressful conditions

KEY ELEMENTS in KEY ELEMENTS in STRESS TESTING STRESS TESTING

Framework

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Reliability of Data Reliability of Data

Stress Testing involves the use of models based on unexpected events on a practical basis

Documentation and Access to database is important Data should be sufficient to capture the downside change as well as the pre-event and post-event dynamics so that the critical risk factors are also captured

Choice of risk factors in determining the explanatory

power

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Survey Portfolio & Environment Survey Portfolio & Environment

Preliminary work necessary:

Management & personnel in bank involved in stress-testing have to arrive at a

consensus regarding the scenario or series of scenarios to be “stressed”,

An agreed upon “benchmark” which can also be used in subsequent studies, e.g.

historical worst-case scenario and to help

define the KRIs for future benchmarking

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Identify Risk Factors Identify Risk Factors

This process will go hand-in-hand with the model and scenario chosen

Different types of risk factors may suit different economic environments or types of stress tests, e.g.,

with Asian financial crisis, risk factors could be market factors like interest rates, and currency exchange fluctuations

with dotcom bust, default probabilities or

unemployment figures could be used as risk factors

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Construct Stress Tests Construct Stress Tests

Once the basic prerequisites are satisfied:

scenario chosen, KRFs defined, relevant data collated

Next step is to construct the stress test

based on the above in terms of dimensions

of evaluation and interpretation of results

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Dimensions of Evaluation Dimensions of Evaluation

Risk:

Severity & range: Loss Quantum & Range of loss quantum, e.g., varying the loss given

default (recovery rate)

Frequency & range: Probability of loss, e.g.,

varying the probability of default

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Scenario Analysis Scenario Analysis

Causes

Failure of relevant risk

factors

Scenario (s) (Potential Event)

Severity of potential loss

Frequency of potential loss

Range of frequency Range of severity

Typical severity

Typical frequency

Evaluation

e.g. THB crash e.g. THB crash

(+ ( + ∆THB) – sensitivity analysis Severity of change in KRF

Failure of relevant risk

factors Scenarios 1, 2, Scenarios 1, 2,

… …

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Output of Stress Test Output of Stress Test

Output & severity of loss dependent on how much the risk factors are “shocked”, e.g., PD (probability of default) for mortgage loan

increased from 3% (in normal times) to xx%

(e.g., 12%-20%) in stressed environment

Also dependent on multi-factor effects &

interdependencies, e.g., oil price hike to >US$ 40 per barrel and stock market battered by 5% drop

Next, sound & best practices

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7. Types of Risk Factors

8. Categories of Stress Tests

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7. Types of Risk Factors 7. Types of Risk Factors

Counterparty Counterparty

Deterioration in ability and/or

willingness to pay:

• PDs

• LGDs

• Credit Spreads

Environmental Environmental

• Financial Market factors

• Industry

• Economic

• Regulatory

• Political

• Sociological

• Ecological

Model Model

• Assumptions

•Holding period

Analytics Analytics

• Correlation

• Transition Matrices

• Volatility

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• EMU

• Y2K

• Enron

• Sept. 11

• SARs outbreak

• Succession

• Concentrations

• Linkages

• Sudden Illiquid market

• Credit

components of securities

• Volatility of credit spreads

• Default assumptions

• Products with uncertain cash flows

• Structured products &

complex derivatives

• Emerging

markets & difficult to handle risks

• Yield curves building

assumptions

• Pricing models

• VaR & capital models

• Asset/Liability model

• Term Structure and yield curve levels & shapes

• Term structure &

relationship of volatilities

• Price shifts in equities, sectors, indices

• Currency, commodity price shifts

• Spreads and basis relationships

8. Categories of Stress Tests 8. Categories of Stress Tests

Portfolio Mix

& Markets

Model Assumptions

Product Complexity

Credit &

Liquidity Sea Change

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Agenda

Agenda – – Session 2 Session 2

A Roadmap to Designing a Stress Testing Model

Credit Risk Stress Testing

The ABC of Stress Testing

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Session 2 Session 2

Spreadsheet examples for stress testing in:

Market risk Credit risk

Coverage of printed notes

Tolong! Ask questions!

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9. Sound 9. Sound

& Best

Practices Practices

Stress Stress Testing Testing Decision Decision Sequence Sequence

Assumption:

Data & MIS Sufficient &

Capable – ideal state

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10. Implementation Challenges 10. Implementation Challenges

(Q&A) (Q&A)

Alternatives 1. Lack of data

Boot-strapping

Theoretical distributions & model Proxy benchmarking

Peer group (overseas) comparison, e.g.

mortgage loan default in neighboring countries

etc

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10. Implementation Challenges 10. Implementation Challenges

(Q&A) (Q&A)

Alternatives 2. Lack of risk analysis tools

Spreadsheet prototypes

Qualitative judgment (expert opinion) regarding choice of parameters and risk factors & model – expert system

Macro-impact of changes in Balance Sheet, Asset & Liability

etc

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10. Implementation Challenges 10. Implementation Challenges

(Q&A) (Q&A)

Alternatives

3. Lack of real-time MIS & expertise

Spreadsheet prototypes

Start at sub-organization or initial group of customers, e.g., consumers

Training & continuing education

Learn from others’ experiences

etc

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Other Considerations Other Considerations

It is also important to conduct stress tests based on assumptions that are less complicated for

management buy-in.

The stress test results ideally should yield, other than the “loss amount”,

information about say, the key risk drivers or factors that have a high explanatory power

i.e., they can explain the loss of the worst-case scenario up to a high degree – see example

Stress Tests also yield different loss amounts

based on degree of severity

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Stress Test Scenarios:

Accounting for explanatory power of different risk drivers

97%

271%

-13%

-8%

-5%

DJIA FTSE100

NIK225 Report 3

94%

264%

-13%

-8%

DJIA FTSE100 Report 2

74%

206%

-13%

DJIA Report 1

Explanatory Power Loss of Portfolio

Value Relative

changes Risk factors

Reports

1. Leaving all other risk factors unchanged, a move of -13% in the DJIA would lead to a relative loss of 206%

2. Leaving all other risk factors unchanged, a simultaneous move of -13% in the DJIA and of -8% in the FTSE100 would lead to a relative loss of 264%

3. etc.

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Table: Loss on the cash flow in 3 different scenarios

USD 183.9 mil 0%

-50%

Major crisis

USD 116.3 mil 0%

-30%

Midsize crisis

USD 58 mil 0%

-15%

Minor crisis

Loss JPY

IDR THB

Scenario

• The results provide a considerably more drastic picture of

the loss potential of the given transaction than the VAR

measure, calculated to be USD 16 mil, by MC simulation.

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SOME USEFUL BENCHMARKS OR SCENARIOS

Most impact on Asian banks in recent times:

•1997 Asian crisis

•2001 Tech Meltdown

•9/11 Terrorist Attack

•2002 Bali bombing

•2003 SARS outbreak

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Scenario Building: An Example

The Impact of Global Interest Rates on Local Rates:

Several Possible Scenarios

?

THB JPY

ECB US

Multiple Scenarios

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DEPTH & BREADTH OF STRESS TEST STUDY

Stress Test methods are hierarchical

- Sensitivity Analysis: broader in coverage - Scenario Analysis: more focused on

specifics

- “Full-Blown” Stress Test: the ultimate in coincident extreme conditions leading to:

“THE PERFECT STORM”

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Sensitivity Analysis

Scenario Analysis

Full-Blown Stress Testing

Depth Depth

Breadth

STRESS TEST METHODS

(A) Hierarchy & Overview

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Overview of Stress Test methods Overview of Stress Test methods

Sensitivity Analysis: Shock risk factor by large no of

“standard deviations”

Typically VAR-based

use EVT to analyze 99.9...% quantile consistent with daily risk management takes into account probability of event

Scenario based: Define scenarios that could hurt include “the unexpected” (e.g. merger risk)

consider highly correlated crashes forward looking

Other “what-if” scenarios

Full-Blown Stress Test: The perfect storm

- subject scenarios above to multitude and coincidence of extreme events and pressures

Accessory methods:

- Forward vs. Backward looking

- Full revaluation vs. portfolio sensitivities

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Sensitivity Analysis Sensitivity Analysis

10 mil series 2

7 mil series 1

98.70%

VAR Extreme Value Theory (EVT) Model

-10 0 10 20 30 40 50 60 70 80 90

-15 -10 -5 0

Loss

Frequency

Series1 Series2 98.7% confidence

a) Using EVT

b) N X Std. Deviation

c) Tweaking correlations & volatilities

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1 c1 c2

1 c3

1 c1 + 15% c2 + 15%

1 c3 + 15%

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Portfolio: 3 assets Portfolio: 3 assets

$10 mil portfolio:

1) 500 Citicorp shares with nominal value of

$5 mil

2) 150 Euroyen Dec futures with nominal value of $3 mil

3) 50 QQQ (NASDAQ ETF) shares with

nominal value of $2 mil

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r1, r2, r3 = 0 σ ₁ = 15%

σ ₂ = 13%

σ ₃ = 20%

ρ ₁₂ = 0.5 ρ ₁₃ = 0.3 ρ ₂₃ = 0.4

1 ρ ₁₂ ρ 13 = 1 0.5 0.3

1 ρ ₂₃ = 1 0.4 = M

1 = 1

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VAR VAR

Var (N std dev) = 1 0.5 0.3 **15%N5**

√(15%N5 13%N3 20%N2) * 1 0.4 13%N3 **1 20%N2**

= VAR (2 std deviation)

= √ (5.88)

= 2.42

Or With a 95% confidence interval, the value of the portfolio will not decline by $ 2.42 mil

If N = 1.65, then it’s 90% confidence interval

If N = 3, then it’s 99% confidence, with VAR = $3.64 mil

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1 c1 c2

1 c3

1 c1 + 15% c2 + 15%

1 c3 + 15%

SEE SPREADSHEET EXAMPLE

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Scenario

Scenario - - based based

Event or Scenario Risk Analysis Event or Scenario Risk Analysis

0.3%

-2.2%

2.4%

-8.3%

-33.1%

-11.2%

Tech-Wreck

-5.5%

-17.6%

-13.5%

-16.8%

-23.5%

-12.9%

Russian Crisis

-1.8%

-0.2%

-1.9%

-2.6%

-7.2%

-6.9%

Asian Crisis

-2.2%

-0.4%

-8.4%

-3.4%

4.3%

1.9%

Mexican Peso Crisis

8.1%

-4.5%

-3.2%

7.8%

-0.6%

-2.0%

Euro Crisis

-3.4%

-2.1%

-16.8%

-7.9%

-13.1%

-10.4%

Gulf War

-0.5%

0.0%

-2.4%

-10.8%

-13.4%

-20.5%

Black Monday

GBP JPY

NIKKEI FTSE

NASDAQ S&P

Shock Names

User-Defined Events

Historical Events

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THE ASIAN MARKET THE ASIAN MARKET

The Asian Contagion The Asian Contagion

The Asian Crisis

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The Asian Contagion

ASIAN

CURRENCIES DECLINE

MARKET LIQUIDITY

DRIED UP

CREDIT SPREADS WIDENED

EQUITY FELL

INTEREST RATES UNSTABLE

FINANCIAL SYSTEM

UNDER STRESS

DEFAULTS INCREASED ENTERPRISE

LIQUIDITY DRIED UP

DECLINING CREDIT QUALITY

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EXAMPLE:

STRESS TEST ASIAN CRISIS

•Pre-Thai Baht crash (July 1997)

•Post-Thai (impact on other markets)

1 0.41

JP

..

1 0.34

MY

..

1 0.61

TH

..

1 0.56

ID

..

1 0.72

0.7 HK

..

0.72 1

0.6 SG

0.41 0.34

0.61 0.56

0.7 0.6

1 US

JP MY

TH ID

HK SG

US CCY

11 8

16 14

15 23

10 Volatility

Annual Correlation & Volatility (%) matrix

6-month correlation

& volatility matrix

3-month correlation

& volatility matrix

“PERFECT STORM” Environment :

Introduce China factor – Yuan devalued in the midst of crisis!

**GRANULARITY OF DATA

June 1996 June 1997 June 1998

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Potential Scenarios Potential Scenarios

Asian credit card business still emerging

But, with economic downturn, consumer credit card default will be a relatively new and potentially a “hot- spot” for a new type of NPL – Korean situation

Can the same thing happen in SE Asia?

Possible scenario to stress test?

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