Stress-Testing a UK Retail Bank

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1 Stress-Testing a UK Retail Bank Executive Summary This article discusses stress and scenario testing the mechanism through which firms understand and prepare for a range of realistic adverse circumstances. For retail banks this includes a particular focus on the impact of economic cycles. The article sets out a GlobeRisk perspective on the minimum standards that a UK retail bank will need to meet to satisfy the needs of the FSA within their capital setting assessment process. Introduction Over the last 10 years or so four major trends have emerged in the supervision of financial services firms: - less prescription and more principles (or guidance); - placing the onus on their supervisees particularly senior management - to show that regulated firm are well managed and have adequate liquidity, capital and other financial resources (rather than this being primarily a matter for the regulators). - improving the extent and quality of performance and risk data within regulated firms and across the industry overall - improving the documentation of risk management processes and infrastructure within regulated firms and holding senior management accountable for effective and consistent execution. The FSA has been at the forefront of this movement and one of their key focus areas is requiring firms to execute Stress and Scenario (S&S) tests to better demonstrate their management expertise, liquidity and capital sufficiency in adverse situations. The future of stress and scenario testing can be found in the FSA discussion paper DP 05/02 ( However, this is not yet a formal requirement and is so outside the scope of this article. Current stress and scenario test requirements are set out in the FSA consultation papers CP 06/03, which is the UK implementation of Basel2, and CP 06/09. The latter has little further impact on retail banks, so, for simplicity, this article will focus on CP 06/03. The Stress & Scenario Testing Requirement Basel2 is principally a capital requirements approach for bank and non bank lenders focussing on: - credit risk - operational risk - market risk outside any trading books held in Treasury operation However, CP06/03 goes a great deal further, consolidating in key principles from the earlier FSA Prudential Source Book which was not implemented for banks when introduced for UK insurance companies in Thus, GENPRU to require that a firm must have in place... sound, effective and complete processes, strategies and systems.. whilst at all times maintaining overall financial resources (particularly capital and liquidity) in respect of the risk areas set out in table 1. 1

2 Table 1 Risk Areas set out within CP06/03 & GENPRU (R) 2 Risk Area GlobeRisk view of typical relative importance to a pure retail bank Credit risk ***** Operational risk ** Liquidity Risk (i.e. funding risk) *** Trading book market risk - (Insurance risk) - Concentration risk (5) ** Residual risk (1) * Securitisation Risk (2) - Business Risk (3) ** Non-trading Book Interest Rate Risk * Pension Obligation Risk (4) *** (Brief Notes) (1) Residual risk refers to the effectiveness of credit mitigation techniques including the residual value of loan collateral (2) Securitisation risk refers to the effectiveness and degree of risk transference achieved by transactions. (3) Business risk refers to ability to carry out a stated business plan (4) Pension obligation risk refers to the likelihood and amount of non planned payments to a company pension scheme (5) Concentration risk refers to a reduction in assumed levels of diversification as a result of large transactions, geographical focus, related transactions and/or collateral and so forth The reader can see that the FSA now expect all firms to have an effective Enterprise wide risk management framework/capability, although a firm only needs to consider the items in table 1 to the extent that they are (or could be) significant. GENPRU gets the ball rolling on Stress and Scenario testing, requiring... appropriate tests to identify and analyze a range of realistic adverse circumstances and events. In essence, the purpose of Stress and Scenario tests is to inform on the additional financial and liquidity resources needed in difficult conditions; particularly economic recessions and industry cycles. Although several definitions of stress and scenario tests all in use, the definitions that follow are common and will be used for the purpose of this paper. Stress tests refer to (significant) changes in single parameters within risk assessment models, whilst Scenarios involve multiple parameter changes; both, to understand and consider the impact if, particular periods of history were to repeat themselves (as amended for the current environment and risk portfolio) challenging economic developments were to occur over the next 3-5 year period 2

3 situations or events that are of particular concern or interest were to occur; for example, tension in the middle east leading to increased terrorist activity in the UK, a local flood, etc etc. Table 1 offers three important implications for successful Stress and Scenario testing it is important for a retail lender to demonstrate the importance (or lack of it) of each of the eleven areas in respect of its own operations and to demonstrate effective risk management in respect of all significant areas the FSA will be expecting extensive Stress and Scenario tests for credit risk and significant efforts in respect of funding risk and pensions obligations (at least for those firms with significant current deficits on defined benefit schemes). The FSA will have the capability to benchmark Stress and Scenario testing efforts across the industry. The Objective Stress and scenario tests provide an important consideration within the capital assessment approach of the FSA, known as SREP (or Supervisory Review and Evaluation Process). SREP is the mechanism through which the FSA will assess a firms Individual Capital Adequacy Assessment Process (ICAAP). The overall situation is that the FSA expect firms to have both plans and capital and liquidity resources sufficient to survive a recession or business cycle. In CP 06/03 the FSA have moved away from prescribing a precise target for firms to hit but, these are generally understood to be as follows: demonstrate stress and scenario tests in the context of a 3-5 year planning period, including consideration of liquidity and capital planning ability to meet capital requirements in a one-in-25-year type downturn including allowance for credit migration ability to survive just a 1 in 1000 year event or situation were this to occur over the next year offsetting factors such as active management of the balance sheet, capital planning and other management activity can be included providing that good evidence exists to support the reasonableness of the assumptions made and a firm s willingness to undertake actions proposed. Mandatory stress and scenario tests Some stress and scenario tests are required from all firms. These are: a 200bp parallel shift in relevant interest rate curves to assess the non trading bank interest rate risk referred to in table 1. a stress test of credit risk capital requirements in an economic down turn (the original Basel2 document only requires this for firms holding model approval waivers so the FSA requirement is super equivalent ). This must include a consideration of ratings migration. 3

4 Minimum Standards? In this section we set out our view as to minimum levels of Stress and Scenario (S&S) tests for a typical pure UK retail bank which does not use an Economic Capital (EC) model (a good EC model can satisfy several S&S areas by itself). For the avoidance of doubt it is assured that the bank does not have a financial markets trading business beyond normal treasury operations. Liquidity resources; for a typical pure retail bank liquidity (or funding) risk is a function of the mix between wholesale and retail funding and the stickiness of these in adverse conditions. The key scenarios here are; an adverse credit rating event on the organisation or an industry wide flight to quality. (The credit rating event will be driven by actual credit losses and recessionary conditions which should be included within the modelled balance sheet). Generally speaking liquidity risk only arises from wholesale funding and professional funding which has been classified as retail since it uses a published rate. Stress tests are then made on the stickiness assumptions to demonstrate robustness. Funding risk is a key regulatory expectation because, ultimately, banks only fail as a result of an inability to fund themselves. That said, funding risk will only be significant in a typical UK retail bank if more than, say, 20% of funding comes from wholesale (or semi-wholesale) sources. Credit risk; this is the key S&S area in a retail bank - if the bank has a Basel2 model waiver, Pillar 1 stress tests are required to demonstrate an understanding of the ranges of model parameters over plausible but adverse economic scenarios. Here, model refers to credit risk measurement scenarios. An effective way to execute this test is to research, or if necessary guess with conservatism, important scorecard parameters in the early 1990 s. In principle, credit line drawdown and loss given default relevant to this period should already be included within any approved models so further work should not be required. - under ICAAP (or Pillar 2), the key requirement is to demonstrate an understanding of risk weighted asset/ (RWA) calculations (with today s portfolio) if the economic environment of the early 1990 s was to reoccur. This needs to include rating migration to model the deterioration in credit quality and also limit drawdown. An effective way to execute this test is either to use scorecard parameters relevant to the early 1990 s directly, to re-assess the credit quality of the current portfolio, or to use a credit risk assessment distribution from that era, amending it for conditions that are no longer relevant for example different business acceptance criteria. The second method is easier to apply but will generally give a more conservative result. It is less straightforward to give guidance on credit line drawdown in recession, since modern approaches to their management (based on flexible IT and behavioural scorecards) are so much better than those of twenty years ago. Nevertheless consideration and inclusion is required. - a further important test is to consider plausible but serious adverse economic developments against a 3-5 year business planning. 4

5 The economic scenario with the most serious impact (although it may be implausible over any particular 3-5 year planning period) is normally a deflationary recession in which retail deposits increase, lending volumes decrease, asset prices decrease and unemployment rises causing significantly higher credit delinquency, lower collateral realisation and higher residual loss in default. Non trading book market risk. For retail banks taking a serious approach to Asset Liability Management (ALM), particularly dynamic behavioural modelling, this is likely to be diminimis. If it is not, the organisation is, in effect, taking significant structural interest rate risk. The mandatory test mentioned earlier is sufficient for most banks. More would be needed if this were a significant risk area. In reality, an ALM bank is exchanging structural market risk for modelling risk so, in principle, one should consider extremes in the behavioural ALM modelling parameters. That said, the FSA have yet to focus on this area as a stress test expectation. Operational Risk. An Advanced operational risk status bank should not need further S&S tests top. Basic and standardised organisations should, at least, assess the impact of key event situations based on their assessment of key operational risk exposures to produce a top 10 set of loss scenarios. Pensions obligation risk. The primary risk scenario is a fall in interest rates with limited increase in equity and/or property markets. A 200bp parallel UK interest rate move combined with zero change in equity and property price levels would be a simple test to apply, albeit rather a conservative one. Concentration risk, primarily arises within lending books and (for typical UK retail banks) is related to geographical or occupation based borrower issues. An early 1990 s RWA test as set out above should cover this area adequately without a further requirement. Concentration risk is a key FSA concern, since the FSA consider the CRR (the Pillar 1 minimum) to be appropriate only for well diversified and well-controlled firms, probably operating internationally. GlobeRisk believes that for most UK retail banks concentration risk concerns are overplayed for two reasons - firms operating nationally with less than, say, 40% exposure to London and the South East; or smaller firms with less than, say, 40% exposure to a single area should normally be sufficiently diversified to respond adequately to an economic recession. - the RWA stress test referred to earlier will normally represent a much tougher capital requirements position than the CRR unless, the economy is already in a more severe recession Business risk primarily emerges as sales volume and privacy issue relative to fixed operating costs. Stress and scenario tests should be considered within planning processes, setting out an appropriate management response to maintain financial resources. 5

6 This article is about stress and scenario testing rather than ICAAP. However, in passing, GlobeRisk believe that, for most banks, the binding constraint for ICAAP will be the RWA test i.e. capital requirements for the current book in a 1 in 25 year recession. To our mind, this is the key starting point for the FSA in considering capital requirements. That is not to say that management actions will not be considered, only that they need to be robust to that situation. Summary Stress and Scenario tests cannot be avoided. The FSA will seek to see two objectives met tests which inform management about the potential for near term adverse developments tests which contribute directly to ICAAP (capital requirements setting) discussions Fortunately, as the reader will see from this article, carrying out the analysis is relatively straightforward. The moral of the story, when it comes to Stress & Scenario testing, is that if you aim at the right target you have a good chance; not only to hit the target but to score well too. 6