Stressing the importance of stress testing

Eva Kelly 21.10.2015

There is nothing like a near death experience to make one reevaluate a situation and strive to make that situation better for the future. The Global Financial Crisis (GFC), and the aftermath that is still unfolding, has unsurprisingly stirred up a fear of another disaster amongst many bankers and managers within financial intuitions.

They are now focused on how to prepare for such disasters, what are the best policies to prevent it from occurring again and also the most effective way to respond if it flares up. 

To be explained in simple terms, stress Ttsting is a form of deliberately intense testing which is used to determine the stability and effectiveness of given systems and policies. It is a process of testing far beyond ‘normal’ operational occurrences, often to the point of breaking, in order to observe results. It is then from these results that best practices and policies are derived in order to proactively work on eradicating risk which could cause a disaster, as well as be prepared if by some means a disaster does occur so that minimal damage and loss results. 

Although stress testing was present in many jurisdictions prior to the GFC it wasn’t until after the fallout, when the enormity of the damage caused came to light, was there a unified consensus that pre GFC stress testing, including regulations such as Basel II, had not been comprehensive enough. Most tests which were carried out prior to the 2007 fallout which were based on Basel II emphasised that participants were to focus on simple and concrete factors in total isolation under one or two almost predictable scenarios. A significant oversight was that the interplay of many fundamental factors such as adjustments, both major and minor, made by bankers, customers and governing bodies were deemed to be low priority tests and often were totally overlooked as a risk at all. There was very much a one size fits all when it came to earlier stress testing and it was this static testing that in hindsight did not provide policy makers and managers with adequate preparation for the chaos that ensued.

Stress testing has evolved considerably in the past few years. There is now much more of an emphasis on the how and why tests are showing certain results as opposed to the previous thinking. Bankers and supervisors alike must now make a much greater effort to analyse and explain decisions rather than just coming to conclusions without examining the process. Stress testing is also no longer being carried out in isolation to other processes within organisations. Stress scenarios are being incorporated into everyday practises such as Capital adequacy, Liquidity monitoring as well as risk analysis and management. Many of the regulatory guidelines which have come in to play since the GFC, such as Basel III and IFRS 9, have also had stress testing as a prominent component to effectively prevent the development of risk and financial loss.

Basel III calls for tests with variances in time horizons. This can be anything from a 30 day acute shock to more severe disasters which feature impairment for a year or more. According to the Basel III guidelines it should be assumed that stress can be derived from a combination of both systematic and company-specific sources and tests should emphasis financial institutions continually being dealt wild cards that would affect their creditworthiness along with access to and cost of funding. On a national and regional level supervisors are encouraged to tailor testing scenarios to best suit both their economy and financial services sector as well as size and specific characteristic risks. It is highlighted in the guidelines that these test conditions are the minimum that institutions should be prepared for.

As a direct result of the Basel III and IFRS 9 guidelines and the pressures which managers are under to meet the expectations of such tests, there has been a significant demand for Risk Professionals throughout the Financial services Market. We currently have a number of roles in Capital Adequacy/Forecasting,, ICCAP AND ILAPP reporting, Operational and Financial risk as well as Risk Modelling, but to name a few. If you are an experienced Risk professional or are interested in making the move to the Risk Industry please do not hesitate to contact ourselves here at Morgan McKinley.

Eva Kelly's picture
Associate Consultant
ekelly@morganmckinley.ie

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