COMPREHENSIVE CAPITAL ANALYSIS AND REVIEW FRAMEWORK AND STRESS TESTING
In my search to effectively make a submission on a portal of one of world’s most recognized financial institutions ,I came across CCAR as an abbreviation. CCAR is Comprehensive Capital Analysis and Review (CCAR) and it is a ?United States regulatory framework introduced by the Federal Reserve to assess, regulate, and supervise large banks and financial institutions – collectively referred to in the framework (BHCs). BHCs means bank holding companies.
The assessment is conducted annually and consists of two related programs:
The core part of the program assesses whether:
The assessment is performed on both qualitative and quantitative bases. The Federal Reserve may order banks to suspend their planned capital distributions to shareholders until the target capital balance is restored.
Stress testing is a risk management technique utilized in the??evaluation of?the potential effects on an institution’s financial condition, of a set of specified changes in risk factors, corresponding to exceptional but plausible events. Stress testing is essentially critical after long periods of benign economic and financial conditions, when fading memory of negative conditions can lead to complacency and the underpricing of risk. It is also a key risk management tool during periods of expansion, when innovation leads to new products that grow rapidly and for which limited or no historical experience is available.
Stress testing attempts to determine the impact of situations where the assumptions underlying established models used in managing a business break down. This applies equally to valuation models, models of individual risks and models that aggregate individual risks.
Stress testing can also be used to assess the impacts of customer behaviour arising from options embedded in certain products – particularly where the impact is not easily modeled under extreme events. Stress testing includes scenario testing and sensitivity testing.
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Scenario testing:
Scenario testing adopts a hypothetical future state of the world or nature to define changes in risk factors that would affect an institution’s operations. This will normally involve changes in a number of risk factors, as well as ripple effects that are represent other impacts that follow logically from these changes and related management and regulatory actions. Scenario testing is typically conducted over the time horizon appropriate for the business and risks being tested.
Sensitivity testing:
Sensitivity testing typically involves an incremental change in a risk factor (or a limited number of risk factors) which have to deal with providing answers to what if questions. ?It is typically conducted over a shorter time horizon, for example an instantaneous shock. Sensitivity testing requires fewer resources than scenario testing and can be used as a simpler technique for assessing the impact of a change in risks when a quick response or when more frequent results are needed (OSFI,2009).
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Why Stress Testing should be undertaken
Stress testing should form a component of enterprise wide risk management system. A stress testing program as a whole should be actionable, playing an important role in facilitating the development of risk mitigation or contingency plans across a range of stressed conditions. It should feed into the institution’s decision making process, including setting the institution’s risk appetite, setting exposure limits, and evaluating strategic choices in longer term business planning.
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An organization’s stress testing program should serve the following purposes:
·???????Risk identification and control – Stress testing should be included in an institution’s risk management activities at various levels, for example, ranging from risk mitigation policies at a detailed or portfolio level to adjusting the institution’s business strategy. In particular, it should be used to address institution-wide risks, and consider the concentrations and interactions between risks in stress environments that might otherwise be overlooked.
·???????Providing a complementary risk perspective to other risk management tools – Stress tests should complement risk quantification methodologies that are based on complex, quantitative models using backward looking data and estimated statistical relationships. In particular, stress testing outcomes for a particular portfolio can provide insights about the validity of statistical models at high confidence intervals, for example those used to determine value at risk(VaR).
As stress testing allows for the simulation of shocks which have not previously occurred, it should be used to assess the robustness of models to possible changes in the economic and financial environment. Stress tests should help to detect vulnerabilities such as unidentified risk concentrations or potential interactions between types of risk that could threaten the viability of the institution, but may be concealed when relying purely on statistical risk management tools based on historical data.
·?Supporting capital management – Stress testing should form an integral part of institutions’ internal capital management where rigorous, forward-looking stress testing can identify severe events, including a series of compounding events, or changes in market conditions that could adversely impact the institution.
·Improving liquidity management – Stress testing should be a central tool in identifying, measuring and controlling funding liquidity risks, in particular for assessing the institution’s liquidity profile and the adequacy of liquidity buffers in case of both institution-specific and market-wide stress events.
?General Considerations for stress testing.
Stress testing programs should take account of views from across the organization and should cover a range of perspectives and techniques.
The identification of relevant stress events, the application of sound modeling approaches and the appropriate use of stress testing results each require the collaboration of different senior experts such as risk controllers, economists, business managers, traders and actuaries. Institutions should also use a range of techniques in order to achieve comprehensive coverage in their stress testing program, including quantitative and qualitative techniques to support and complement models and to extend stress testing to areas where effective risk management requires greater use of judgment.
Institutions should have written policies and procedures governing the stress testing program. The operation of the program should be appropriately documented.
The assumptions and fundamental elements for each stress testing exercise should be appropriately documented, including the reasoning and judgments underlying the scenarios chosen and the sensitivity of stress testing results to the range and severity of the scenarios. The level of documentation should be based on the nature and purposes of the stress testing. For example, documentation of ad hoc sensitivity tests for tactical decisions may be less elaborate than the documentation of enterprise-wide stress tests used for strategic decision making. An evaluation of fundamental assumptions should be performed regularly or in light of changing external conditions. The results of the assessments should also be documented.
An institution should have a suitably robust infrastructure in place, which is sufficiently flexible to accommodate different and possibly changing stress tests at an appropriate level of granularity.
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The infrastructure should be able to aggregate comparable risks and exposures across the institution. It should allow for reporting to senior management and the board in a timely manner throughout the fiscal year. The infrastructure and information systems should be sufficiently flexible to accommodate a timely increase in the frequency of ad hoc sensitivity testing to support senior management’s response to rapid changes in the operating environment and also for purposes of responding to the concerns of external stakeholders and regulators.
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An institution’s stress testing infrastructure and information systems should be commensurate with the nature and complexity of the institution and its risk profile. For example, greater risk factor volatility and shorter time horizons for management actions require infrastructure and information systems that accommodate more frequent stress testing in those areas.
An institution should regularly maintain and update its stress testing framework. The effectiveness of the stress testing program, as well as the robustness of individual components, should be assessed regularly and independently.
Assessments of effectiveness should be qualitative as well as quantitative, given the importance of judgments and the severity of shocks considered. Areas for assessment should include effectiveness of the program in meeting its intended purposes, documentation, development work, system implementation, management oversight, data quality and hypotheses and assumptions used.
Since the stress test development and maintenance processes often imply judgmental and expert decisions (e.g. assumptions to be tested, calibration of the stress, etc.), the independent control functions such as risk management and internal audit should also play a key role in the process. In particular there should be an independent review (e.g., by internal audit) of the adequacy of the design and effectiveness of the operations of an institution’s stress testing programs.
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?Methodology and Scenario Selection
Stress tests should cover a range of risks and business areas, as well as at the institution-wide level. An institution should be able to integrate effectively, in a meaningful fashion, across the range of its stress testing activities to deliver a complete picture of institution-wide risk.
A stress testing program should consistently and comprehensively cover product-, business- and entity-specific views. Using a level of granularity appropriate to the purpose of the stress test, stress testing programs should examine the effect of shocks across all relevant risk factors, taking into account interrelations among them.
Comprehensive stress testing programs should consider the institution’s most material and significant risks. Where relevant and material, such risks may include:
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1. credit risk, including counterparty and reinsurance risk
·???????market risk, e.g.,
·???????general market
·???????specific ?cash flow mismatch
·???????interest rate
·???????foreign exchange
??? commodity
2 insurance risk, e.g.,
·???????mortality
·???????morbidity
·???????claim frequency and severity
·???????persistency and lapse risk
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·???????liquidity risk
·???????operational and legal risk
·???????concentration risk
·???????contagion risk
·???????risk to reputation
·???????securitization risk
·???????new business risk
·???????regulatory risk
·???????inflation risk
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The impact of stress tests is usually evaluated using one or more measures. The particular measures used will depend on the specific purpose of the stress test, the risks and portfolios being analyzed and the particular issue under examination. A range of measures may need to be considered to convey an adequate impression of the impact. Typical measures used are:
·???????asset and liability values
·???????level of impaired assets and write-offs
·???????accounting profit and loss
·???????economic profit and loss
·???????required and available regulatory capital
·???????economic capital
·???????liquidity and funding gaps
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Stress testing programs should apply across business and product lines and cover a range of scenarios, including non-historical scenarios, and aim to take into account system-wide interactions and feedback effects (e.g., second order and macroeconomic effects).
Stress tests should be conducted flexibly and imaginatively, in order to improve the likelihood of identifying hidden vulnerabilities. A “failure of imagination” could lead to an underestimation of the likelihood and severity of extreme events and to a false sense of security about an institution’s resilience.
The institution should assess the impact of severe shocks and periods of severe and sustained downturns, including its ability to react over the time horizon appropriate for the business and risks being tested.
Institutions should use stress tests to identify, monitor and control risk concentrations. To adequately address risk concentrations, the scenario should to be firm-wide and comprehensive, covering balance sheet and off-balance sheet assets, contingent and non-contingent risks, and should give due consideration to actions beyond contractual obligations that might be undertaken to preserve reputation. Further, stress tests should identify and respond to potential changes in market conditions that could adversely impact an institution’s exposure to risk concentrations.
Stress tests should feature a range of severities, including events capable of generating the most damage, whether through size of loss or through loss of reputation. A stress testing program should also determine what scenarios could challenge the viability of the institution (reverse stress tests). Such tests may be useful in uncovering hidden risks and interactions among risks.
Stress tests should be geared towards events and business areas that might be particularly damaging for the institution. Areas which benefit in particular from the use of stress testing are business lines where traditional risk management models indicate an exceptionally good risk/return trade-off; new products and new markets which have not experienced severe strains; and exposures where there are no liquid two way markets.
Institutions should conduct reverse stress tests. A reverse stress test starts with a specified outcome that challenges the viability of the firm. One example of such an outcome would be that over a short time period, the firm incurs a very large loss that challenges its viability. The analysis would then work backward (reverse engineered) to identify a scenario or combination of scenarios that could bring about such a specified outcome. The reverse stress test induces institutions to consider scenarios beyond normal business settings that would include events with contagion and systemic implications.
As part of an overall stress testing program, a deposit-taking institution should aim to take account of simultaneous pressures in funding and asset markets, and the impact of a reduction in market liquidity on asset valuation. Funding and asset markets may be strongly interrelated, particularly during periods of stress. An institution should enhance its stress testing practices by considering important interrelations between various factors, including price shocks for specific asset categories; the drying-up of corresponding asset liquidity; the possibility of significant losses damaging the institution’s financial strength; growth of liquidity needs as a consequence of liquidity commitments; taking on board affected assets; and diminished access to secured or unsecured funding markets.
As part of an overall stress testing program at an insurance company, specific consideration should be given to important interrelations between various risk factors. For a life insurer, changes in economic conditions can significantly affect policyholder behaviour such as lapse rates, utilization of options within an insurance contract, and morbidity and recovery rates. For a property and casualty insurer, changing economic conditions will not only influence investment income and company expenses, but can also, particularly in times of inflation, lead to higher claims and loss reserves.?