ALM Stress Testing: Gaining Insight on Modeled Outcomes

Transcription

1 ALM Stress Testing: Gaining Insight on Modeled Outcomes 2013 Financial Conference Ballantyne Resort Charlotte, NC September 18, 2013 Thomas E. Bowers, CFA Vice President Client Services ZM Financial Systems

2 Presentation Outline The five principles of stress testing How to develop, implement and maintain a stress testing framework Critical issue: seek out vulnerabilities to inform decision-making on material exposures Describe types of ALM stress tests to consider Limitations to stress testing In estimating necessary levels of risk capital, the primary concern should be to address those disturbances that occasionally do stress institutional solvency Alan Greenspan,

3 Components to Interest Rate Risk Repricing (mismatch) risk Assets, liabilities have different timing to next repricing (could mean maturity) Embedded options risk Options permit members or counterparties to alter the timing to future principal and interest cash flows Basis risk Offering rates between assets, liabilities at same term point on the curve change by different amounts Yield curve shape risk Repricing concentrations at term points on the curve 3

4 ALCO Roles and Responsibilities Identifying & measuring market risk factors Carry desired level of mismatch, volatility, basis, yield curve risks; mitigate per policy Identify & measure liquidity (cash flow) and funding access; prepare contingency funding plan Manage the investment and borrowing portfolios Establish controls over risk-taking; validate models Evaluate and implement strategies that may improve the risk/reward profile of the A/L mix Risk and compliance communication ALCO must adopt a strategic view of risk 4

5 Linkages Between Willingness to Assume Risk, the CU Balance Sheet, Stress Testing and Capital Planning Risk Appetite Strategic Plan State of the World Severe Economic Conditions Poor Economic Conditions Baseline Economic Conditions Target Capital and Liquidity Minimum Capital and Liquidity CUs must hold sufficient capital and liquidity to support the strategic plan through different scenarios, economic states 5

6 Definition of Stress Testing A forward-looking assessment of the potential impact of various adverse events on the CU For IRR, design extreme market environments, shock assumptions about key behavioral options For liquidity, impose strain on cash flow, funding DO NOT CONFUSE STRESS TESTS WITH PREDICTION. Stress tests are tools for revealing adverse impacts from unlikely but plausible events Stress testing is a fundamental element to risk identification and measurement 6

7 Building Blocks to Stress Testing Governance and Internal Controls Communication, Program Refinement Credit Risk Interest Rate Risk Liquidity Risk Operational Risk Reputation Risk Stress Test Outputs Stress Test Methodologies, Scenario Selection Multiple Severities Emerging Exposures Supervisory Assessment Sensitivity Analysis Scenario Analysis Reverse stress Testing Management Action, Risk Appetite Alignment Stress Testing Framework 7

8 Principles of ALM Stress Testing Principle 1: The CU s stress tests should be tailored to and sufficiently capture its exposures & activities Design stress tests to identify potential downsides to strategy and unanticipated risks Stress tests should be relevant to ALM exposures contained in the CU s business mix. For example, IRR in mismatched floaters is best revealed using yield curve twist scenarios What scenarios cause callables to perform poorly? Stress test the investment/borrowing portfolios along with the entire balance sheet Source: Principles for sound stress testing practices, BIS, May

9 Principles of ALM Stress Testing Principle 2: The stress test framework should employ multiple approaches Models are imperfect representations of reality Even with robust model development, implementation and use, assumptions, data limitations and degree of stress applied result in measurement uncertainties Stress testing should comprise scenarios along a spectrum of events and severity levels The design of the stress test should not be so complex as to undermine its integrity or clarity Source: Principles for sound stress testing practices, BIS, May

10 Sensitivity Analysis Type of stress testing where certain inputs or assumptions are shocked without an explicit underlying reason or real-world outcome Change one or more key variables with the objective of understanding the range of outcomes Instantaneous rate shocks (e.g., +/- 200 bp) Yield curve slope and twist risk (e.g., +/- 300, 400 bp) Basis risk Shock/stress modeled behavioral assumptions Shock/stress other market-related assumptions 10

11 Scenario Analysis Type of stress testing where historical or hypothetical scenarios are applied, driven by some logical narrative or story explaining the event Common approach for liquidity risk assessments E.g., CU-specific funding disruption caused by credit losses, sudden discovery of operational losses (fraud) Systemic events: loss of the securitization market, stock market crash, market liquidity dries up, agency spreads widen, subprime mortgage meltdown, etc. Examine institution-specific and systemic events individually AND in combination 11

12 Reverse Stress Testing Type of stress testing where a known adverse outcome is assumed, and then deduce the types of events that could lead to that outcome Traditional Stress Test Reverse Stress Test Shock P&L P&L Shock What economic scenarios threaten CU survival? Define a set of plausible worst case risk factors Certain level of unemployment leads to credit losses that breach regulatory capital ratios Bad loans trigger a funding liquidity event so severe that the CU cannot meet its obligations 12

13 Principles of ALM Stress Testing Principle 3: An effective stress test framework is forward-looking and flexible Use historical stress data as a guide, but also challenge conventional assumptions Idea is to include events that could plausible occur, but do not actually occur in the historical data set Conduct ad hoc tests to address emerging risks Stress tests need to be dynamic to reflect changes in the CU s on- and off-balance sheet activities Include expert judgment in an iterative process Source: Principles for sound stress testing practices, BIS, May

14 Principles of ALM Stress Testing Principle 4: Stress test results should be clear, actionable, well-supported & inform decision-making Assess stress testing activities for validity of assumptions, severity of tests, results soundness Document the CU s stress testing processes, including a description of qualitative inputs Prepare reports to adequately convey approaches, results and potential remedial actions Consider strengths/limitations of each test when making decisions on adverse impact outcomes Source: Principles for sound stress testing practices, BIS, May

15 Principles of ALM Stress Testing Principle 5: the CU s stress testing framework should include strong governance and internal controls Board has ultimate responsibility for stress testing ALCO reports on stress test design, results, policy compliance, limitations, reliance on judgment Obtain independent validation to ensure integrity of processes, results and to control for model risk Is the stress testing framework functioning as intended to identify/measure extreme events and facilitate decision-making? Source: Principles for sound stress testing practices, BIS, May

16 Historical US Treasury Curve Movements January 2003 to September 2009 Source: Federal Reserve Statistical Release H.15 16

17 Scenario Analysis for Interest Rate Risk Designing a scenario around a plausible historical event Next step is to scale this scenario for severity (make it more extreme) 17

18 Historical Rate Distribution For 10CMT January 1970 September 2009 (477 mos.) How to compute percentile: sort data from low to high, select the p (n 1) + 1 observation 18

19 Historical Rate Distribution For 3B January 1970 September 2009 (477 mos.) 19

20 Sensitivity Analysis Rate Shocks Revised IRR regulatory guidance in 1996 called for +/- 200 basis point shocks over one year 2010 guidance suggests +/- 300 and 400 bp Form of shocks: Instantaneous, continuous and sustained (level) Ramped, delayed and stylized shocks over time (earnings simulation) In stochastic simulation, the yield curve is shocked and random up/down paths evolve into the future Stress policy should describe form of forward rates 20

21 Yield Curve Shape Risk Issues Many balance sheet products are sensitive to rate changes at various points along the yield curve Examples: Callable bonds act like barbell structures as curve tilts Mismatched floaters: variable rate CMOs indexed to long end of curve (e.g., 5-year CMT, 10-year CMT) Adjustable-rate mortgages possess period/lifetime interest rate caps that are sensitive to forward rates 21

22 Stress Testing for Yield Curve Risk Approaches to shock slope/shape of the curve Curve Shift: fixed income traders define slope shift as change between the 10-year and 2-year term points How should the rest of the curve shift in sympathy? Level and slope can be shocked together: example at right illustrates bull steepener, bear flattener sensitivity stress tests 22

23 Stress Testing for Yield Curve Risk Approaches to shock slope/shape of the curve Curve Point Shift: ad hoc shifts to individual term points on the yield curve Useful to replicate historical shocks or reveal earnings and duration sensitivities at specific term point(s) Graphic below illustrates stress tests published by Bank of America in their annual SEC filing 23

24 Stress Testing for Basis Risk Repricing of assets, liabilities tied to same term point on different curves can vary, creates basis Asset earns Treasury, funding priced off LIBOR/Swap Key risk to measure/control for hedging strategies Municipal yields tend to shock on a TE basis Stress testing approach to reveal basis is to shock Treasury and LIBOR/Swap by different amounts 24

25 Assumptions Stress Testing Modeled Behaviors, Market Drivers Stress testing should include sensitivity analysis on assumptions that most influence model output Loan prepayment rates Driver rates for mortgage refinancing, new volumes Non maturity deposit decay rates New volume repricing sensitivities (beta) Valuation assumptions: OAS, volatility The types of stress scenarios to analyze depend on the risk profile of the CU: adjust stress tests as conditions change 25

26 1.5% NMD, 10-Year Final Maturity Beta =.25 Up/.75 Dn: 0.25% Floor Attrition Amplifies Convexity 26

27 Limitations of Stress Testing Internal data and assumptions contain gaps Numerous decisions on stress test specification means heavy reliance on risk manager judgment The IRR tool may not be up to the challenge The IRR tool cannot give absolute certainty on implications of assumed events, impacts No single stress test can capture all risks nor give probabilities to the impact of all adverse outcomes Community institution IRR is slowly moving to integrate loan default and recovery rates into ALM 27

28 Best Practices in Stress Testing Do use data collected from stress testing towards having a meaningful impact on business decisions Do develop internal procedures that makes stress test scenarios part of the management culture Examine new products to identify potential risks Review scenarios as economic environment evolves: look for new approaches to evaluate exposures Don t underestimate likelihood of severe events ALCO Should Discuss Key Model Assumptions with the Board 28

29 (919) Farrington Road, Suite 201 Chapel Hill, NC