Reverse Stress Testing : Promises to Keep
Dr. Sunando Roy
Advisor @ Central Bank of Bahrain | Risk Leader, PRMIA ?Audit Leader Network Member , Institute of Internal Auditors (IIA), ? Fellow , International Compliance Association(FICA) ? Fellow, UC Irvine I Published Author
Stress Tests have become an integral part of risk management in banks, yet, the existing models suffer from a major flaw. In their effort to replicate the unknown , based on the knowledge of known , modeling often resembles guesswork and not adequate representation of the complexity that often envelops stress. And since you cannot back test a stress situation, in their absence of data points, model accuracy remains alien to the whole process of stress testing. The Boards thus find little use of the stressed parameters other than their role in overcoming the challenge of supervisory stress tests and save banks of costly capital requirements which tend to stifle growth and profitability in its quest for a stable financial landscape.
And it is for this reason model reviews of stress testing by experts focus more on the assumptions and controls of stress tests rather than its computational ability to capture real world complexities.
As the Silicon Valley Bank episode points out, any amount of liquidity stress under usual stress scenarios would have placed the Bank with comfortable LCR and certainty NSFR, but the way the real world played out on the eve of March 9 2023 was way beyond the imagination of any risk managers arsenal. The utility of stress testing is more directional than quantitative . To say the least, models are not praised for its directional bets. They are hailed for their precision. Stress testing , to be fair, puts up a dismal show of precision mathematics.
However, it’s lesser known relative, Reverse stress testing , is by design a better yardstick. While reverse stress testing requirements are also in place in several jurisdictions, it has not received the attention it deserves. Michael Barr, Federal Reserve Vice Chair of Supervision, emphasized its importance:
“Reverse stress testing can help banks identify hidden vulnerabilities by exploring tail risks and revealing scenarios that could lead to failure.”
?By its very construct, Reverse stress test uses a precise defined result as a starting point. The result may be a breach of Liquidity Coverage Ratio threshold of 100 per cent, a non performing loan share of 2 per cent or a lower capital threshold. By using the reversing approach parameter changes are identified and associated scenarios or events which lead to the results specified. Such Inversion reduces short sightedness of a crisis which is recognised weak point of conventional stress test and to reduce any false sense of security to the decision maker. Without doubt, at idiosyncratic if not. systemic level, reverse stress tests provides additional reference points for the susceptibility of banks.
?Since 2010, European credit institutions have been regularly confronted with the regulatory requirement to perform reverse stress test, though a definitive approach to Reverse Stress testing did not emerge in ECB guidelines before 2018. During the interim period the industry attempted to a variety of approaches, rudimentary or slightly more nuanced. The impetus for improving reverse stress tests did not come from Bank Boards nor was there a discernible regulatory push. Basel Committee also did not go beyond publishing some broad principles or collating the range of practices. Academic world remained disconnected from industry in this field. As a result, little progress is seen in the reverse stress testing domain.
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Thankfully, The EBA guidelines in 2018 on institution stress testing (EBA gl 2018 044) was a game changer.
It did clarify and detail the current fundamental expectations of European supervisors regarding the procedure and methodological framework for carrying out reverse stress test the requirements set out in other regulatory documents in Europe for carrying out reverse stress test. Accordingly EBA gl 2018 04 form the central point of reference for existing regulatory requirements the essence of EBS basic expectations on reverse stress test one reverse stress test must form an integral part of Institute's entire stress testing programme. Accordingly, reverse stress test are increasingly being integrated consciously and thus equally stringently into the stress testing governance. An increase in rigor when conducting reverse stress test should help to increase transparency for current and future potential weakness and situations that threaten their existence from a going concern perspective. Improved reverse stress test procedures can reduce the crisis short sightedness disaster myopia for decision makers and supervisors alike. While we are still far from ideal state of affairs , there is some progress. And Reverse Stress testing, to me, holds more promise compared to its traditional predecessor in this regard. I expect more industry academic collaborations in reverse stress test models that can be gainfully applied for crisis preparedness.
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References
1. Basel Committee on Banking Supervision. Stress Testing Principles. Bank for International Settlements, October 2018. https://www.bis.org/bcbs/publ/d450.pdf
2. European Banking Authority. Guidelines on Institutions' Stress Testing (EBA-GL-2018-04). July 2018. https://www.eba.europa.eu/regulation-and-policy/internal-governance/guidelines-on-institutions-stress-testing
3. Financial Conduct Authority. "SYSC 20.2 Reverse Stress Testing Requirements." FCA Handbook. Accessed December 23, 2024. https://www.handbook.fca.org.uk/handbook/SYSC/20/2.html
4. Financial Conduct Authority. Finalised Guidance: Reverse Stress-Testing Surgeries – Frequently Asked Questions (FG11/07). May 2011. https://www.fca.org.uk/publication/finalised-guidance/fg11_07.pdf
5. Committee of European Banking Supervisors. CEBS Guidelines on Stress Testing (GL32). August 2010. https://www.eba.europa.eu/sites/default/documents/files/documents/10180/16094/ee1e7b7b-5b45-4758-bc64-22b159c3f66c/ST_Guidelines.pdf
6. European Securities and Markets Authority. Guidelines on Stress Tests under the Money Market Funds Regulation. July 2019. https://www.esma.europa.eu/sites/default/files/library/esma34-49-115_mmf_guidelines_on_stress_tests.pdf
7. Bank for International Settlements. "Stress Testing – Executive Summary." Financial Stability Institute, March 2021. https://www.bis.org/fsi/fsisummaries/stress_testing.htm
8. Moody's Analytics. "Is Reverse Stress Testing a Game Changer?" Moody's Insights, September 2013. https://www.moodysanalytics.com/insights/whitepapers/2013/is-reverse-stress-testing-a-game-changer
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Transforming Systems to build Brands?
2 个月Hold their feet to the fire...accountability at all costs! 2008 was a house of cards and long memories for small businesses and families that "trusted" the banking system.
Clearing & Treasury Risk Consultant
2 个月Dr Roy Such an insightful commentary can come only from a practitioner with such varied and deep experience. Reverse Stress Test is the way to go for the stakeholders to understand and assess the apparent stability of the system they are part of. The question however is the extent of disclosure, even to stakeholders. I agree that a balancing is required between use as a management tool and disclosure to stakeholders. Are we ready to incentivise this in an appropriate manner?
Advisor @ Central Bank of Bahrain | Risk Leader, PRMIA ?Audit Leader Network Member , Institute of Internal Auditors (IIA), ? Fellow , International Compliance Association(FICA) ? Fellow, UC Irvine I Published Author
2 个月Stress tests, like any other model type, suffer from limitations. I am at the same time a fan and a critic of stress test models. I do work toward implementing supervisory stress testing, despite its weaknesss. The model failure in a changing world is well described by Jon Danielsson in his recent CEPR contribution ( attached) https://cepr.org/voxeu/columns/when-risk-models-hallucinate So, i believe stress tests will improve in future, With the help of large datasets and AI, but for now, though it takes you beyond VaR, it is still in an unknown territory outside the stochastic comfort zone
Credit Risk | Strategy | Pricing | Products | Innovation
2 个月Insightful! I still think if common stress test was so good , Silicon Valley bank wouldn’t have fallen like it happened.