Stress Testing Framework

Properly stress testing measures of risk is a complicated activity that few companies have done well.  In this blog we take a look at a complete framework for stress testing.

Over the last few months, news has emanated from several sources across the planet about the viability of bringing the global banking community into a Basel III realm. There are arguments from the UK, the US and elsewhere that Basel III is just technically too difficult to achieve and too costly in capital reserves. 

Stefan Ingves, the chairman of the Basel Committee on Banking Supervision has indicated that the body is listening to complaints from the likes of the Bank of England and the Federal Deposit Insurance Corporation that the rules are too complicated to be effective.

Basel III Amendments | Bob's Guide 

Although few regulators have given a complete itinerary of what they deem too hard, the real headache for financial institutions is the Basel III liquidity rule set. Basel III is separated into two key documents; A global regulatory framework and an international framework for liquidity risk.  It is the latter mandate which is most problematic but it is the liquidity risk framework which is most important for resolving the problems in banks risk management systems.

Liquidity Risk

You only have to read the first four pages of the Basel III-Framework for Liquidity to realize this regulatory requirement is going to be a big deal.

The LCR builds on traditional liquidity "coverage ratio" methodologies used internally by banks to assess exposure to contingent liquidity events.  The scenario for this standard entails a combined idiosyncratic and market-wide shock that would result in ... and then the document goes on to list several scenarios that banks might wish to consider a capital cover for.

Basel III Amendments | Basel III  

In the end, if you are a bank and you want to meet this requirement, you are going to need to have the risk department develop a stress testing framework for liquidity risk which considers ALL assets being traded.  This is the Pièce de résistance of true risk measurement and it is what should be in place; yet, very few banks have been able to even design an enterprise risk stress testing framework that is integrated, why is that?

I put it down to many inherent failings in banks risk departments but we can summarize these flaws into four unresolved hurdles:

[1] The CRO must inherently understand the tacit aspects of each risk measurement discipline (Market, Credit and Operational Risk) and how they interrelate.

[2] The banks risk department must have a clear vision on how a liquidity risk framework may operate. This should consider all of its moving parts, from scenario generation to transfer pricing.

[3] The liquidity risk framework needs to be able to unify measurement for the differing trade booking practices found in the bank. 

[4] The risk unit needs to find a way to aggregate the outcome of risk scenarios that are applied against each risk discipline and it must then summarize the measurement outcome into a single representation of exposure. 

In effect, banks will have to create a unique framework for liquidity risk and few institutions have achieved this to date. However, until they do, their risk systems will always be incomplete.

Stress Testing Framework

When we criticize something, anything, we need to put our money where our mouth is and offer some kind of solution or an alternative. If we don't do this, we just become a spectator in the peanut gallery as I have said all too often before on this blog. So then, to avoid being a risk management voyeur, I have taken to design a liquidity risk stress testing framework that does the needful for banks.

Stress Testing Framework | Causal Capital

You will have to click on the image map to view it, actually you'll probably need to grab the spreadsheet file to read the finer details contained within. This spreadsheet can be downloaded from the following LINK.

What it does do is cover all our moving parts required for stress testing liquidity risk. In the centre of the diagram a complete risk pricing feed is shown, the activities of the entire project have been listed, a section on stress testing from the Bank for International Settlements has been lifted in and the models used for stress testing have been itemized and described.