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Written By:
Dr Marie-Paule Laurent
Olivier Salom
Tamar Joulia
Frdric Van Weyenbergh
Written by
Dr Marie-Paule Laurent
Managing Partner
mplaurent@riskdynamics.eu
+32 495 268 771
Olivier Salom
Manager
osalome@riskdynamics.eu
+32 487 326 184
Tamar Joulia
Senior Expert
tjoulia@riskdynamics.eu
+32 495 590 101
Frdric Van Weyenbergh
Associate Partner
fvanweyenbergh@riskdynamics.eu
+32 473 995 147
Risk Dynamics
Belgium: +32 2 340 00 90
London: +44 7970 462213
Netherlands: +31 20 2402750
Info@riskdynamics.eu
Introduction
Prior to the financial crisis that started in 2007, most financial institutions did not perform stress tests
from a comprehensive firm-wide perspective across all risk types and businesses. Instead, they
mainly relied only on individual risk models, assuming that historical trends constituted a good basis
for assessing the development of future risks. The crisis has revealed serious flaws in relying solely
on such an approach.
These models did not capture the possibility of severe shocks or how the combination of these
vulnerabilities behaves at a market level, amongst others due to their lack of interaction, which in
extreme conditions can drastically change the behaviour of fundamental economic risk factors. The
effects of this flaw were dramatically amplified as historical correlations proved to be unreliable.
Exposed by the market volatility, it became clear that most financial institutions had not paid sufficient
attention to these limitations of traditional risk models.
As market turbulences continue to affect financial institutions, stress testing has grown significantly in
scope and importance. Senior management have established comprehensive firm-wide risk
assessment processes in which stress and scenario testing play a material part, allowing better
informed and more timely decision-making. In particular, stress testing is considered as a key tool to
inform senior management about alignment of the institutions risk profile with the Boards risk
appetite, under various circumstances.
This white paper focuses on the use of stress testing for proactive risk management beyond
regulatory requirements.
This paper is divided into five sections:
Section 1 Types of Stress Testing: We outline the context for different types of stress tests,
including sensitivity analysis and scenario testing.
Section 2 Context for Stress Testing: We introduce context in which these tests may be used.
Section 3 Stress Test Process: We introduce an approach to conducting Stress Tests that brings
together these tests and provides a sustainable approach that enables organisations meet their
objectives
Section 4 - Creating value with Stress Testing: We demonstrate how the stress testing framework
can be integrated in to strategic business decisions
Section 5 In conclusion: Lessons learned and conclusions from Risk Dynamics experience.
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Trigger
1
Activities
Origination
Specify:
Type and objectives of tests
Scope and perimeter
Characteristics of the
scenarios: likelihood/duration
Reference date
Time horizon of the impacts
Level of granularity
Measures / metrics
Stakeholders
Planning and milestones
Approval and reporting
3
Scenarios
Identify
The scenarios that are
relevant in light of the
origination, the external
environment and the
institutions business model
Select :
The scenarios from the
repository
The baseline
Or launch a request for:
Additional scenario
4
Impacts
Collect data
In line with the
specifications defined in the
origination
Select models and
methodologies
E.g. internal model
Statistical methodologies
and expert-based
techniques
Actions
Reporting
Communicate
Internal management (e.g.
Group Board, ALCO, FRC,
Divisions Board)
Disclose
Local regulator or other
bodies (EIOPA, etc.)
Market participants
Embed
ORSA report
Management Actions
Reporting Template
Implementation
Origination Sheet
Tools
Repository
Narrative description
Categories
Systemic or idioscyncratic
Historical or hypothetical
Real of financial
Rapid chrystallisation or
protracted effect
Assessment
Likelihood and severity
Stressed risk factors
Contagion effects
Data
Fit for purpose database
Models
Methodologies
The stressed risk factors are
first translated into stressed
risk parameters. The latter
are then applied to the
portfolios and risk types
(with and without additional
risk mitigations). Impacts
are measured as deviatons
from the baseline. Results
are finally aggregated.
Categories
Actions directly under firm
control
Actions that require a
counterparty
Timeliness
Immediately
Early warnings
Materialization of risks
Risk Appetite
Risk Dynamics
Stage 1 - Origination: The key elements of the scenarios and stress tests are defined, e.g. the
type and objectives of the stress tests, their scope and perimeter, the characteristics of the
scenarios (likelihood, duration), the time horizon of the impacts, the level of granularity, and the
measures or metrics that will summarize the results (in absolute and relative terms).
Stage 2 Scenarios: Consists of first identifying all the scenarios that are relevant for the
institution. The set of scenarios that will be actually used is then selected from the institution own
repository of scenarios. The latter includes a narrative description of the scenarios, their likelihood,
and the type of shocks to which they relate (systemic, idiosyncratic, etc.).
Stage 3 Impacts: Running the tests demonstrates the impact of the scenarios on the selected
metrics. This three step activity begins with the translation of the stressed risk factors into internal
stressed risk parameters. The latter are then applied to the portfolios and risk types so that the
impacts can be measured. Finally, the results are aggregated at Group and entity levels.
Stage 4 - Actions: The outcomes of the exercise are analysed, including the extent to which the
risk profile under stressed circumstances is aligned with the chosen risk appetite. The impacts of
actions can then be tested based on the tools used to assess the impacts of the scenarios or by
means of expert judgments. If needed, risk mitigating actions can be proposed to the senior
management.
Stage 5 Reporting: This phase aims at communicating the results to the internal senior
management of the institution (the Board or the relevant body depending on the type and purpose
of the stress tests). It might also be required to disclose the results to the local regulator or other
regulatory bodies (EIOPA) and market participants and to embed them in the ORSA report.
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Financial Resources
>
Risk Profile
Quantitative View
Capital Capacity
(actual / target)
Capital
Risk exposure
(actual / target)
Earnings Capacity
(actual / target)
Earnings
Risk exposure
(actual / target)
Liquidity Capacity
(actual / target)
Liquidity
Risk exposure
(actual / target)
Action Plans
Risk
Capacity
Qualitative View
Stress &
Scenario
Testing
Risk Assessment
Risk Dynamics
Risk Profile
Benchmarked against risk appetite, the assessment of significant losses (such as in earnings or in
value) associated with adverse events is used to identify where the institution should establish
contingency, continuity plans or take mitigating action.
This assumes an appropriate definition of risk appetite, reflecting the accepted variations in Earnings,
Capital and Liquidity positions as well as the types of risks an institution is willing to be exposed to.
Using Stress Testing to drive performance
Once established, the stressed positions of the institutions portfolios can be benchmarked against its
tolerance for risk, and specific actions taken when the risk profile evolves toward a green, orange or
red zone:
Target
level
Recommended
Action:
Minimum
level
GREEN
ZONE
ORANGE
ZONE
RED
ZONE
Possible re-allocation
of excess financial
resources
Execution of the
risk mitigation
plan
For each Key Risk Indicator (KRI), the institution determines two levels of performance:
The target or strategic level, reflecting the business strategy;
The minimum level of performance (or maximum level of risk) is based on the institutions
tolerance for changes in particular risk / performance indicators.
In the green area, the institution should consider reallocating excess resources to other business
initiatives.
Even in adverse scenarios, the indicators should not drop below the maximum level of acceptable
risk, but remain in the orange area.
Delivering Value
Calculated over an adequate time horizon, to reflect the cumulative and remote effect, scenario and
stress testing provide a range of forward-looking views on institutions risks, and thereby contribute to
a risk sensitive capital and budget planning
The budgeting exercise is based upon a range of scenarios, covering the appropriate time horizon
(typically 3 years) and material firm-wide risk sensitivities.
In practice, the institution investigates the variations between the baseline and the adverse (but
plausible) scenarios to help controlling adherence to the chosen risk appetite.
This contributes to:
A more efficient allocation of financial resources during the budgeting process.
The allocation can be conducted along two complementary dimensions:
Per business, in line with the institutions strategic priorities and relative value creation per
business line;
Per risk category (credit, market, liquidity, underwriting, operational risks...) in line with the
institutions tolerance in terms of losses and capital / liquidity requirements.
A proactive management of risk appetite, by integrating risk and finance planning into the same
yearly process, so that the budgets are aligned with the institutions risk.
A proactive management of portfolio sensitivities across and within risk types.
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10
In Conclusion
Tell what the story tells...
In many instances, the characteristics of the scenarios (e.g. story, likelihood, severity, duration of the
shocks, horizon of the impacts) and the internal metrics used for the assessment are not precisely
described, if at all.
Stress testing, as part of an integrated approach to risk management can add value and
speed to business decisions, as it provides strong evidence about the performance of the
business under different conditions.
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