Stress testing and capital planning - the key to making the ICAAP forward looking PRMIA Greece Chapter Meeting Athens, 25 October 2007

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1 Stress testing and capital planning - the key to making the ICAAP forward looking Athens, *connectedthinking

2 Agenda Introduction on ICAAP requirements What is stress testing? Regulatory guidance on stress testing How do we link this to the ICAAP? What are supervisors looking for? Slide 2

3 Introduction CEBS ICAAP Principles: VIII. The ICAAP should be forward looking ICAAP should take into account the institution s strategic plans and how these relate to macroeconomic factors; Internal strategy for maintaining capital levels can incorporate factors such as: - Loan growth expectations; - Future sources and uses of funds; - Dividend policy. Capital plan should explicitly state the institution s objectives and the time horizon for achieving them; Larger institutions should conduct stress tests taking into account: - Risk specific to the jurisdiction(s) in which they operate; - Particular stage of the business cycle. Slide 3

4 Introduction The element structure of the ICAAP Step 1: Assess the capital allocated against three elements/risk categories Element 1 Pillar 1 risks Element 2 Risks not fully covered under Pillar 1 Element 3 Risks not covered by Pillar 1 (not a comprehensive list) Market Residual credit risk Concentration Pension Transfer Operational Credit Securitisation Interest rate risk in the banking book Liquidity Reputation Settlement Business Underestimation of credit/operational risk in standardised/basic indicator approach Underwriting Step 2: Stress capital amount for external factors, including through the cycle Element 4 External factors Strategic Economic and regulatory environment Access to capital Slide 4

5 Section 2 Introduction on ICAAP requirements What is stress testing? Regulatory guidance on stress testing How do we link this to the ICAAP? What are supervisors looking for? Slide 5

6 Stress testing Stress testing a few definitions Stress testing is defined as a generic term describing various techniques used by financial firms to gauge their potential vulnerability to exceptional but plausible events ; Stress tests generally fall into two categories: - Sensitivities (or single-factor tests), which seek to identify how portfolios respond to changes in relevant economic variables or risk parameters; - Scenarios, which seek to assess the resilience of financial institutions and the financial system to an exceptional but plausible scenario. Slide 6

7 Stress testing Sensitivities / single-factor tests Benefits: - Can be run relatively quickly; - Intuitive link between factor and outcome of the test; - Used by senior managers to form an initial view of the impact on the firm of a move in a financial variable. Several approaches: - Risk parameters are moved instantaneously by a unit amount (e.g. a parallel shift in interest rates by 200bp); - Worst case historical movements for each risk factor (e.g. most significant fall in house prices in last 40 years). Slide 7

8 Stress testing Scenario tests event-driven vs. portfolio-driven approaches * Source: Stress testing at major financial institutions: survey results and practice (BIS) Scenario formulated based on plausible events (e.g. Black Monday); Assesses how these events might affect the relevant risk factors in a firm s portfolio; Scenarios often formulated at the request of senior management, sometimes motivated by recent events. Slide 8

9 Stress testing Types of scenarios Historical Scenarios Relies on significant event experienced in the past Tend to be more fully articulated and involve less judgement May be less suited to the actual risk profile of institution May not adequately reflect advances in risk taking Based on actual data Hypothetical Scenarios Significant market event that has not yet happened Potentially more relevant to the risk profile of a firm Labour-intensive and require a lot of judgement Might lack support from management and/or business level Historic data can be used to identify relationships Choice depends on a number of factors, including the relevance of historical events to a given portfolio as well as available resources In practice, hybrid scenarios are quite common, using historical market moves as inputs but not necessarily linked to a specific crisis Scenarios need to balance a trade-off between realism and comprehensibility Qualitative discussion at the start of the process is important scenarios should not rely on mechanical assignment of probabilities Slide 9

10 Stress testing Detailed considerations Time-horizon the horizon normally used is near term rather than long term. A longer time horizon may be more appropriate as some macro economic impact may take more than a year to filter through; Unexpected illiquidity - many crises are characterised by an abrupt lack of liquidity in financial markets; Lack of hedges hedging instruments may be rendered invalid during stress events; Aggregation the process of aggregating the effects of stress tests performed at a risk type or business unit level raises issues regarding diversification benefits and second-round effects; Correlations levels that prevail in ordinary conditions may cease to exist under exceptional events. Slide 10

11 Stress testing Establishing a stress testing framework Determine the objective of the stress test and ensure that reliable data is available: - Risk factors selected must take account of the current position of the bank s portfolio and identify its specific weaknesses; - Stress tests that are not relevant to an institution s current portfolio can provide misleading information to managers. Perform stress test - the approach used will depend on the risk factors analysed; Calculate stress losses using both scenarios and sensitivities; Formal reporting of only a selected set of stress test results: - Helps top management digest the results quickly and take remedial action promptly; - Reporting the results for the same, repeated stress tests allows senior management to monitor more accurately the riskiness of their business. Each stress test should be accompanied by a clear set of pre-agreed plans of remedial action. Slide 11

12 Stress testing Where to start Initial questions for banks senior management Who should be responsible for the stress testing programme? Who should be responsible for designing the sensitivities and scenarios? How frequently will stress tests be performed? How should the bank perform stress tests at a group level? Who should determine which remedial actions the bank should take to alleviate the effects of exceptional events? How much will the major profitability and stability ratios (i.e. liquidity ratios) need to decrease to trigger remedial actions? How frequently should the stress test results be communicated to senior management? Should the results of stress tests be available to investors (via annual reports or discussions with brokers)? Slide 12

13 Section 3 Introduction on ICAAP requirements What is stress testing? Regulatory guidance on stress testing How do we link this to the ICAAP? What are supervisors looking for? Slide 13

14 Regulatory guidance CEBS Principles for stress testing (1) Institutions should conduct adequate and proportionate stress tests on all the risks they have identified as material; Based upon the identification of material risks, institutions should derive material risk drivers that should be subject to stress testing; Institutions should consider historical and/or hypothetical scenarios as applicable; Stress testing should be based on exceptional but plausible events; The frequency of stress testing should be determined in accordance with the nature of the risks to which the institution is exposed and the types of tests performed; Institutions should determine the time horizon of stress testing in accordance with the maturity and liquidity of the positions stressed where applicable. Slide 14

15 Regulatory guidance CEBS Principles for stress testing (2) The management body has the ultimate responsibility for the overall stress testing framework; The stress testing process should be an integral part of an institution s risk management framework, with clear reporting lines and communication in an understandable format; Appropriate documentation should be in place to facilitate the adequate implementation of the whole stress testing framework; Institutions should consider periodically whether stress tests are still adequate. In particular, institutions should ensure that assumptions regarding the risk profile and the external environment are still valid over time Institutions should use stress testing as one (among others) tool to assess the risks in a forward looking manner. In addition to these general principles, there are a number of specific principles for stress tests related to individual risk types (e.g. credit risk, operational risk, market risk, liquidity risk). Slide 15

16 Regulatory guidance Most countries are not providing specific guidance on stress testing Country Austria France Germany Italy Netherlands Spain Sweden Czech Republic, Hungary, Luxembourg and many others National regulatory guidance on stress testing High-level guidance only. Diversification effects should not be included in scenarios tested. Previously published guidance on market and credit risk stress tests. Stress tests should be designed to measure impact of regulatory/economic environmental changes. Specific direction provided on IRR. Appropriate scenario assessments to be performed on a regular basis for liquidity risk measurement. Possible scenarios are described (e.g. default of key borrowers/lenders) Specifications apply in line with proportionality. Minimum sensitivity analysis should be performed on credit risk, concentration risk with regard to the loan portfolio and interest rate risk in the banking book. Stress tests required as key part of the ICAAP process, but without specific guidance. Testing required for capital planning and generic scenarios are suggested (e.g. economic downturn and general deterioration of credit quality). But banks using Standardised Approach need not do this and simply add 10% to Pillar 1 capital, or take account of other risk types. Guidance on use of stress and scenario tests as a means of validating results from risk models. Example of economic downturn stress test is similar to the UK. Mentioned, but no specific guidance on expectation Slide 16

17 Regulatory guidance FSA main stress test requirements Pillar 2 general requirements (GENPRU & ) Stress and scenario analyses for each major risk Firm to demonstrate that its plans and capital are sufficient to: - meet its liabilities as they fall due; - survive a recession and meet the Pillar 1 capital requirement through a severe recession (1 / 25 years). Allowance for credible management actions - Gross stress-test deficit without mitigation might imply a discrete capital addon in the Pillar 2 process Incorporate and take into account the results of the tests required under Pillar 1 (e.g. IRB procyclicality) Carried out at least annually (but more frequently if significant changes) Proportionate and relevant to the firm Slide 17

18 Section 4 Introduction on ICAAP requirements What is stress testing? Regulatory guidance on stress testing How do we link this to the ICAAP? What are supervisors looking for? Slide 18

19 Linking to ICAAP Capital stress tests Need to distinguish between different types of stress test: Pillar 1 stress tests: - tail test; - Sensitivity analysis. Pillar 2 stress tests: - Capital stress test; - Additional scenarios for pillar 2 risks. 25 October Session Slide 19

20 Linking to ICAAP Element 4 - capital planning and stress testing Objective: - That the firm can meet its capital requirements at all times in a forward looking manner including throughout a reasonably severe economic recession. Why capital planning? - Elements 1 to 3 are static - Will the firm also have sufficient capital tomorrow? Two aspects: - Capital planning; and - Stress testing. The capital stress test is effectively intended to ask the question: Are we able to maintain minimum acceptable capital levels even in periods of stress? Slide 20

21 Linking to ICAAP Capital planning A fully-integrated capital forecast would be linked to the planning and budgeting process, providing forecasts for: - Available physical (book) capital essentially a function of profits, dividends and other capital management activities; - An adjustment of the available physical capital to reconcile to available economic capital and/or regulatory capital; - Required economic capital essentially a function of forecast credit exposures, market risk limits etc. - Required regulatory capital essentially a function of forecast risk-weighted assets. Forecast requirements should be compared with forecast availability. 25 October Session Slide 21

22 Linking to ICAAP Base case (how does management expect the business to develop)? Is the base case reasonable? Strategic risk? Available Capital Capital generated as business grows Capital requirement Additional capital needed as the business grows time Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Slide 22

23 Linking to ICAAP Capital planning and stress testing Realistic base case: - Strategic risk will be considered in assessing the base case; - Supervisors will ask banks to adjust the base case if it is deemed not plausible. An appropriately severe and holistic stress test: - Covering all major risk types; - Considering dependencies between risk types as well as second order effects; - Appropriate effects over time. Slide 23

24 Linking to ICAAP In severe stressed case (pre-management actions) Firm makes losses Capital requirement Capital deficit Available Capital Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 time Slide 24

25 Linking to ICAAP Management actions can influence both required and available capital Required capital Revise limits; Reduce exposures; Change pricing policy. Available capital Raise more capital; Revise dividend policy; Reschedule debt repayments. Are the actions credible? - Management track record; - Cost of implementation; - Reasonable quantification of impacts. Slide 25

26 Linking to ICAAP In severe stressed case (post management actions) Cut dividends Reduced costs Raised extra capital CR (pre) Capital (post) CR (post) Reduced business volumes Capital (pre) Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 time Slide 26

27 Linking to ICAAP Capital requirement need to consider both projected required capital and projected available capital Projected required capital Projected Pillar 1 requirements under stressed scenario + Pillar 2 risks? + Buffer? Projected available capital Starting position + Inflows: profits, new capital raised etc. - Outflows: losses, dividends/share buybacks, maturing sub debt etc = Projected position Slide 27

28 Linking to ICAAP Assessment of capital requirements post stress tests Capital requirement today for stress = capital requirement at stress point less capital generated between today and stress point. P2 P1 Projected P1 Additional required capital Pillar 1 Pillar 2 Today Stress point in 3 to 5 years time (maximum required capital) Slide 28

29 Linking to ICAAP Stress test example how much of today s surplus must be allocated for future stress events? Base case capital plan required capital Base case available capital Surplus Stress case required (after actions) Stress case available (after actions) Surplus Required today for future stress Generated Net required today nil Answer: 20 of today s surplus of 30 must be earmarked to withstand future stress events Slide 29

30 Section 5 Introduction on ICAAP requirements What is stress testing? Regulatory guidance on stress testing How do we link this to the ICAAP? What are supervisors looking for? Slide 30

31 Supervisory expectation Capital stress tests: best practice UK FSA s requirement is a 1 in 25 years event Leading banks assess all possible scenarios, and then reduce these to the 5-10 scenarios which will affect the bank most significantly, and model each of them Scenarios are holistic and occur over time; these are not single factor, instantaneous tests Best practice for each scenario is: - Start with base-case capital forecast - Overlay all components (P&L, BS, Capital) with the stress scenario ( gross stress test) - Identify credible actions that management would take in that scenario - Overlay management actions over the gross stress test ( net stress test) - Demonstrate that the bank would maintain minimum capital ratios over the duration of the net stress test minimum capital can be the bank s own targets or, at the very least, the minimum regulatory requirements. In all cases the latter must be demonstrated. 25 October Session Slide 31

32 Supervisory expectation Stress testing thematic review - best practice Close engagement by senior management Examples cited included CEO involved personally in review and challenge of scenarios, impact and mitigating actions, chief or senior risk officer having personal charge of the stress testing programme. Plausible scenarios which seriously challenge key profitability, business planning and capital assumptions or where mitigating action was constrained Clear and accessible communication of results The FSA strongly emphasised that scenarios should not reflect a complacent bias as a result of the recent benign credit cycle, giving rise to mild scenario impacts. Results should be presented to senior management showing the impact of stress testing over a multi-year time horizon, the effect on a selection of metrics and the possible management actions. Use of group-wide stress testing and scenario analysis to challenge business planning assumptions The FSA expect to see clear and substantive use of stress testing outputs to challenge business planning assumptions. Source: UK FSA s Dear CEO Letter Oct 2006 Slide 32

33 Thank you for your attention!* Contact details: Telephone: All rights reserved. refers to the network of member firms of International Limited, each of which is a separate and independent legal entity. *connectedthinking is a trademark of LLP (US).

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