Guest post by Paul Dobbs, Global Lead Consultant, IBM Risk Analytics.
On September 17, the IBM Banking Summit 2013, will place at the Marriott Marquis in New York City.
You will have an opportunity to hear from IBM experts as well as industry influencers such as Brett King, financial advisor and author, and David O’Connell, senior analyst from Aite Group, on the fundamental and transformational changes sweeping the financial sector.
In this "new normal," adaptation and innovation are necessary for survival, let alone competitive advantage. This is especially true in the realm of enterprise risk management and, in particular, capital management. At the IBM Banking Summit, we’ll be exploring key issues driving capital investments in capital management, the importance of culture and usability in bringing capital management to front-line operations, and the critical importance of linking capital management with enterprise risk data governance.
You are welcome to join us at the event. In the meantime, let’s explore the world of capital management and stress testing at a high level.
Understanding the forces that have fundamentally changed stress testing
The recent global financial crisis revealed that financial institutions and even whole economies are vulnerable and ill-prepared for severe systemic shocks. An extensive effort is now underway to strengthen the financial sector and make banks and other institutions more resilient in the face of unexpected stress.
The hope is that future crises will not lead to governments again being forced to invest billions of taxpayers' money to save the banking system. Regulatory requirements, for example in the form of mandated stress testing, have been introduced to help facilitate this overhaul.
A number of global and regional regulatory bodies have mandated stress testing as an important part of a risk management framework. Since the first supervisor-run stress tests for very large U.S. banks in 2009, regulators have developed something of a dual strategy on stress testing. They have sought to examine the largest banks' capital adequacy through regulator- and bank-run stress tests using standardized scenarios while also pushing banks to improve their internal bank-specific programs of stress testing and capital planning. The aim is to fill a gap in bank risk and capital management regarding the stressed losses that can be generated in severe scenarios.
How are banks to proceed?
It is important that banks do not underestimate the scale of the challenge they face. For instance, Basel III requires more data to be submitted to regulators, more complex calculations to be used, and more stress tests to be performed. It is important that banks have robust technology systems in place that can store and aggregate more data, perform more calculations, and can offer quicker response times.
This need to support regulatory stress scenarios and upgrade internal stress testing and capital planning has left some large banks running complex parallel processes. Even though banks generally prefer developing internal stress testing programs rather than running their data through "one-size-fits-all" supervisory stress testing models, many banks have been shocked by the effort it takes to gather the risk data for modeling idiosyncratic risks at a more "bottom up," granular level.
It's really only now that many large banks are finding time to take stock and evaluate the bigger picture. Indeed, most banks are now addressing some of the broader organizational and cross-risk challenges, as well as the key methodological challenge: making sure stress testing is granular and robust enough to reflect the bank's true, idiosyncratic risk profile, particularly in its credit portfolios.
As a result of all this, financial institutions should consider making the following changes in their approach to stress testing:
Stress testing and scenario analysis need to be integrated, testing several types of risk and the effects on different classes of assets at the same time.
Stress testing and scenario analysis need to be comprehensive and enterprise-wide, for example, testing the effect on capital management and liquidity across the enterprise, as well as for individual business lines.
Stress testing needs to become on-demand, to support the more dynamic approach taken towards functions such as mentioned above - capital planning and liquidity.
Furthermore, financial institutions need to ensure that their risk function works across silos, such as capital, treasury, and asset-liability management to support holistic, on-demand and integrated stress testing and scenario analysis systems. This will not only improve the quality and usefulness of stress testing, but by making it on-demand, firms will help to institutionalize stress testing. Improvements to stress testing will help to fulfill regulatory requirements, and help embed risk awareness into the business by increasing the stress testing of capital and liquidity.
Given the large array of regulations today’s banks are now required to adhere to, so far banks have often taken their cue from the regulator in terms of the degree of economic adversity and range of macroeconomic indicators used to build a scenario. However, there also is an increasing trend for banks to adapt scenarios to capture how risk exposure is shaped by geographic concentrations, product focus and exposure to specific risk factors. As a result, regulators increasingly now favor granular, bottom-up, risk-factor-driven approaches, compared to broader brush, "top-down" approaches. Bottom-up approaches capture the risk nuances of a portfolio, because they track how macroeconomic factors affect the micro risk factors that in turn drive loss rates in the bank's risk models.
What to look for in a stress testing platform
As evidenced during the financial crisis, the old stress testing approach with its segregated view of risk, limited scope and severity of scenarios and incomplete organizational picture of potential risk failed the tests of reality. Banks have recognized this and are in the process of building stress testing environments which are advantageous for their businesses and demonstrate the potential impact of a prolonged economic cycle. Banks need a stress testing function that uses a new, broader approach to risk governance and provides an integrated view of risk encompassing all types of risk (not just capital), but also secondary effects and liquidity risk.
They need to implement a stress testing platform comprising existing risk applications and workflow for the implementation of scenario definition and execution. Furthermore, this platform should also include a sophisticated risk aggregation engine to allow for the aggregation of risk at multiple levels and across different risk dimensions. Finally banks will need the ability to report stress test results in different ways, providing risk, financial and qualitative information to help the business make the right decisions.
Don’t miss the IBM Banking Summit on September 17 to dive deeper into these challenges – register today.
Learn about IBM’s premier solution for enterprise stress testing – IBM Algo Strategic Business Planning. Or check out our whitepaper – Rethinking risk management with strategic business planning.
To learn more about IBM’s Risk Analytics business, go to www.ibm.com/riskmanagement, or follow us on Twitter at @IBMRisk.