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Harmonising macro and micro prudential stress testing

Ahead of RiskMinds International in Amsterdam this December, Hitoshi Mio, Head of International Division at Bank of Japan explores how to find an efficient balance between stress tests and incorporate them into your system as a value add? (Disclaimer: The views in the article are those of the author alone and do not reflect those of the Bank of Japan.)

Stress testing is designed to test the resilience of financial firms or of the financial system against severe but plausible adverse macro-financial scenarios. Macro stress tests run by prudential authorities have the potential to support the authorities’ systemic risk identification and macroprudential policymaking. Micro stress tests run by firms at firm or portfolio level have the potential to support the firms’ risk measurement and management.

Looking back, firms became interested in stress testing in the wake of the financial crises in Asia in 1997 and the turbulent events of the autumn of 1998. A Working Group established by the Committee on the Global Financial System (CGFS) surveyed large international banks about their use of stress tests and found that, in fact, well before the creation of corporate-level programs, individual trading desk managers at many firms had put stress test programmes in place at their own initiative.

Prior to the global financial crisis (GFC), however, the focus of the stress testing was narrowly defined. For example, the stress tests of none of the firms interviewed in the survey integrated market and credit risk systematically. And, many prudential authorities were sceptical about the usefulness of macro stress tests ((CGFS (2000)).

The GFC highlighted substantial deficiencies in risk measurement and management across the financial sector, which promoted fundamental changes in how both firms and prudential authorities would design and use stress testing.

Several prudential authorities have since started to develop and implement concurrent bank stress-testing frameworks. A concurrent bank stress test is a simultaneous stress test of several banks carried out under the direction of a stress-testing authority, such as a central bank or banking system regulator (Dent et al (2015)). Importantly, it adds a macroprudential dimension to bank supervision by helping prudential authorities evaluate the aggregate capital position of firms, as well as their individual capital levels under a common stress scenario.

The first prominent example of the concurrent bank stress test was the US Supervisory Capital Assessment Program (SCAP) conducted by the Fed in early 2009. In a significant departure from the past, the SCAP set a new standard of supervisory transparency in disclosing bank-by-bank estimates of capital shortfalls. With the US Treasury’s backstop in the event that any bank was unable to raise their shortfalls in private markets, this departure was intended to restore public confidence by providing supervisory information about banks' potential losses and capital needs. The SCAP is widely regarded to be one of the critical turning points in stabilising the US financial system.

Former Fed Chairman Ben Bernanke emphasises three benefits of concurrent stress tests as supervisory tools (Bernanke (2013)). First, they complement minimum capital standards by adding a more forward-looking perspective and by being more oriented toward protection against so-called tail risks. Second, they look horizontally across banks rather than at a single bank in isolation, a comparative approach that promotes more consistent supervisory standards. It also provides valuable systemic information by revealing how significant macro-financial shocks would affect the largest banks collectively as well as individually. Third, the disclosure of stress test results promotes transparency by providing the public with consistent and comparable information about banks' financial conditions.

The greater regulatory focus on the concurrent bank stress tests has helped to drive improvements in firms’ own stress-testing capabilities and risk management practices, with bank-wide stress testing now common practice at systemically important banks.

As the global financial environment returns from crisis to normal, the role of regulatory stress testing is also evolving from crisis mode to normal mode. Against this backdrop, prudential authorities have undertaken several initiatives to embed more advanced system-wide stress testing exercises in their macroprudential frameworks.

Some authorities are pursuing more systematic scenario design. The Bank of England’s (BOE) annual cyclical scenario, for example, is calibrated to reflect BOE policymakers’ judgement on the state of the financial cycle (BOE (2015)). By assuming a more severe macro-financial stress scenario when the financial imbalance is deemed to be larger, the overall stress-test results could inform policymakers about the appropriate level of system-wide bank capital buffers. Some authorities are ensuring that the capital requirements implied by stress tests are more integrated into existing capital frameworks. The Federal Reserve Board (FRB), for example, has proposed the introduction of a stress capital buffer. This would simplify their capital regime by replacing the existing 2.5 percent fixed capital conservation buffer with a buffer requirement equal to the maximum decline in a firm's common equity ratio under the severely adverse scenario (Tarullo (2017)). And many authorities are focusing on enhancing their modelling strategies. The European Central Bank (ECB) is actively pursuing the integration of more realistic dynamic features into their model framework, specifically allowing for banks’ reactions, adding a proper liquidity stress test component, and integrating contagion effects as well as two-way interaction with the real economy (ECB (2017)).

Enhancement in modelling strategies is one area where increased interaction between firms and prudential authorities will help both. It will help in two ways. First, developing realistic dynamic features in model framework will require regulatory authorities to deepen their understanding of how firms optimise and manage their portfolios and risks. Second, firms may benefit from interacting with prudential authorities with their significant analytical capabilities and system-wide datasets. To this end, the Bank of Japan (BOJ) intends to make progress in collaborative research with financial institutions in order to improve stress testing and promote its effective use (BOJ (2018)).

In many cases, macro and micro stress tests use the same or similar analytical tools although there are important differences between the two in terms of what they try to identify and for what purpose the results are used. And, if prudential authorities make their models fully transparent, there might be a risk of creating model mono-culture.

How can multidisciplinary expertise employed for macro and micro stress tests complement each other? How can we avoid the risk of creating model mono-culture when firms closely interact with powerful prudential authorities? Is there a net benefit in harmonising macro and micro prudential stress tests? If the answer is yes, there should be a collaborative framework that enhances firms’ risk management as well as the stability of our financial system.

Hitoshi banner

References
Bernanke, B (2013), ‘Stress testing banks: what have we learned?’
BOE (2015), ‘The Bank of England’s approach to stress testing the UK banking system’, October 2015.
BOJ (2018), ‘Financial System Report (April 2018) ’, April 2018.
CGFS (2000), ‘Stress testing by large financial institutions: current practice and aggregation issues’, CGFS Paper No. 14.
Dent, K, Westwood, B and Segoviano, M (2016), ‘Stress testing of banks: an introduction’, Bank of England Quarterly Bulletin, 2016 Q3.
ECB (2017), ‘STAMP€: Stress-test analytics for macroprudential purposes in the euro area’, edited by Stéphane Dees, Jérôme Henry and Reiner Martin, February 2017.
Tarullo, D K (2017), ‘Departing thoughts’

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