By Terry Flanagan

Taking the Stress Out of Stress Testing

Mandatory stress testing by banks as required by the U.S. Dodd-Frank Act and the Basel III bank capital adequacy requirements are taking their toll on risk management professionals.

“Running stress testing for banks is stressful,” said Ron D’Vari, chief executive of NewOak Capital, a financial advisory and investment banking firm. “If a bank reports too little stress losses, markets don’t believe it, and if it reports too much, a bank’s existing equity will be crushed by the new equity that must be raised. The process is more of an art than a science. A lot depends on macro assumptions such as central bank policies, etc.”

The U.S. regulatory environment is challenging banks to quickly develop systems that meet more stringent stress-testing requirements.

“These solutions have generally met the immediate regulatory need but remain labor intensive, process poor and relatively unscalable,” said Eric Ebel, senior director at Moody’s Analytics, a credit rating agency, in a report.

A key element of a stress testing infrastructure is a centralized data platform that consolidates multiple sources of internal and external data.

“As regulatory requirements become more stringent and granular, data management becomes more complex,” said Ebel. “Data infrastructures should be able to capture, validate and integrate data to support both [internal] analytics and regulatory reporting requirements.”

Moody’s Analytics has introduced an enhanced version of its enterprise risk management platform, RiskFoundation, to help banks better manage their Dodd-Frank Act Stress Test and Comprehensive Capital Analysis and Review data and reporting requirements.

Stress tests can either be carried out internally by institutions with assistance from independent experts as part of their own risk management, or by supervisory authorities as part of their regulatory oversight of the banking, insurance and investment management sectors.

The core methodology should be based on the actual internal operating model of the financial institution subject to stress testing, as well as the risk architecture underpinning the data and applications used in implementing stress testing throughout the institution.

“Data gathering is a necessary evil and, in most cases, leads to building permanent business intelligence dashboards that help future ongoing operations,” said D’Vari at NewOak Capital. “The process of arriving at all inputs and assumptions can be tedious but helps the bank organize and provide further transparency for internal and external facts and implied views.”

NewOak specializes in stress testing and valuing complex and illiquid financial instruments, and has analyzed and evaluated over $3 trillion of complex assets in a variety of sensitive legal and regulatory situations.

NewOak was recently called upon to replicate the Comprehensive Capital Analysis and Review stress testing regime for a global portfolio of illiquid asset-backed securities and municipal securities with a very limited amount of time.

The key is documenting and validating the basis for the final conclusions.

“From the outside, it may look like an educated crystal ball,” said D’Vari. “There is always a chance for reasonable experts to disagree, especially during times of economic uncertainty and credit performance.”

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