VRM8 - Stress Testing

Question 1

Describe the rationale for the use of stress testing as a risk management tool

Answer 1

Somewhat forward looking so can see how capital would react to future hypothetical shocks

Question 2

Explain key considerations and challenges related to stress testing, including choice of scenarios, regulatory specifications, model building, and reverse stress testing

Answer 2

When choosing scenarios, have to select appropriate time horizon and assume large changes in key variables.

The model built should then be able to see how relevant risk factors behaved compared to these key variables, and should be able to carry out an analysis on how peripheral factors behaved.

Important also to consider knock-on effects of scenario (possible economic downturn after event etc.)

Reverse stress testing is creating a scenario where the bank fails, but the test must still be plausible.

Regulators require a baseline, adverse, severely adverse, and an internal scenario to be run. Banks required to then submit capital plan and justification for stress model developed.

Question 3

Describe stressed VaR and ES including their advantages and disadvantages and compare determining stressed VaR and ES to that of traditional VaR and ES

Answer 3

Stressed calculated from period of stress, therefore is a conditional VaR and ES given a stressed period. Traditional VaR uses all data from the past one to five years

Useful to give a view of how bad it could be if it got bad again, but difficult to back test

Question 4

Describe the relationship between stress testing and other risk measures, particularly enterprise-wide stress testing

Answer 4

Stress testing should cover all aspects of the bank, the goal being to ensure the bank has enough capital (therefore should be enterprise-wide)

Question 5

Describe the responsibilities of the board of directors, senior management, and the internal audit function in stress testing governance

Answer 5

Board:
- oversee key strategies
- set risk appetite and culture
- define how stress testing carried out (assumptions, scenarios, and models)

Senior managers:
- make sure tests carried out by competent employees
- adhere to appropriate policies and procedures
- challenge key assumptions and models

Internal audit function:
- ensure employees have appropriate qualifications
- documentation is satisfactory
- make sure model is independently validated

Question 6

Describe the Basel stress testing principals for banks regarding the implementation of stress testing

Answer 6

• provide forward looking assessments of risk
• overcome limitations of models and historical data
• support internal and external communications
• feeding into capital and liquidity planning procedures