While the recent stress-testing of banks by the US government garnered a lot of attention, there has been much less focus on the stress-testing procedures of banks in the run-up to the crisis. Or rather, on the clear shortfalls of those procedures.
On that matter, however, the Bank of International Settlements (BIS) has now issued a 20-page report put together by its Basel Committee on Banking Supervision. Unsurprisingly perhaps, its main findings appear to show that internal bank stress-testing practices were in many areas simply inept.
The key finding of the report is:
The financial crisis has highlighted weaknesses in stress testing practices employed prior to the start of the crisis in four broad areas: (i) use of stress testing and integration in risk governance; (ii) stress testing methodologies; (iii) scenario selection; and (iv) stress testing of specific risks and products.
In short, banks either applied the wrong scenarios (too weak); compartmentalized their application of those scenarios instead of applying them to the institution as a whole; and/or failed to address the reactions of specific product portfolios and their effects on others.
Some particularly salient points from the report include:
Prior to the crisis, many banks did not have an overarching stress testing programme in place but ran separate stress tests for particular risks or portfolios with limited firm-level integration. Risk-specific stress testing was usually conducted within business lines. While stress testing for market and interest rate risk had been practiced for several years, stress testing for credit risk in the banking book has only emerged more recently. Other types of stress tests are still in their infancy. As a result, there was insufficient ability to identify correlated tail exposures and risk concentrations across the bank.
Most bank stress tests were not designed to capture the extreme market events that were experienced. Most firms discovered that one or several aspects of their stress tests did not even broadly match actual developments. In particular, scenarios tended to reflect mild shocks, assume shorter durations and underestimate the correlations between different positions, risk types and markets due to system-wide interactions and feedback effects. Prior to the crisis, “severe” stress scenarios typically resulted in estimates of losses that were no more than a quarter’s worth of earnings (and typically much less).
Meanwhile, among the BIS’s very long list of recommendations we find this interesting little tidbit (emphasis from BIS):
A bank should have written policies and procedures governing the stress testing programme. The operation of the programme should be appropriately documented.
The stress testing programme should be governed by internal policies and procedures. These should be appropriately documented.
Does this imply stress-testing in the industry was even more whimsical than anyone may have ever thought?
And, there’s also the following recommendation on applying a reverse-stress test scenario methodology from now on:
Reverse stress tests start from a known stress test outcome (such as breaching regulatory capital ratios, illiquidity or insolvency) and then asking what events could lead to such an outcome for the bank. As part of the overall stress testing programme, it is important to include some extreme scenarios which would cause the firm to be insolvent (ie stress events which threaten the viability of the whole firm). For a large complex firm, this is a challenging exercise requiring involvement of senior management and all material risk areas across the firm.
Which clearly means risk managers never even considered applying the ultimate stress-test of all before — eg. just what would it take to actually blow us up? The findings of that sort of stress-test, of course, would be very interesting indeed.
Related links:
Principles for sound stress testing practices and supervision - BIS
US stress test results - FT Alphaville
