By Jackie McLaughlin
Sungard Managing Director Thomas Day began this session at the Annual Risk Management Conference by emphasizing that stress testing can enable board and senior management to proactively create recovery plans and make strategic decisions for risk mitigation and control in the event of actual stressed conditions.
He went on to say that regulatory capital levels are not a sufficient indicator of insolvency risks. Bear-Stearns, Indy Mac, Washington Mutual, and many others “failed” while being “well-capitalized” under PCA rules.
As stress testing moves downstream from the world’s largest banks—gaining more momentum and attention from various stakeholders (including shareholders and regulators)—regional and community banks must get ahead of the curve by developing a clear and structured understanding of its process, components, and methods.
A stress testing framework should be unique to an institution’s portfolio characteristics. Sungard Senior Consultant Kenneth Yu outlined the steps of the scenario design process:
- Determine stress factors.
- Define scenarios – minimum of three scenarios over a two-year time horizon.
- Determine quantitative link to P&L – micro (bottom-up) stress testing vs. macro (top-down) stress testing.
- Assess impact – comparison of baseline and stressed performance metrics.
- Develop board executive reports.
- Develop strategy play book – high/low impact; faster/slower acting.
Scenarios presented to the organization’s decision makers must be well-presented and
footed to real world events to ensure buy-in and understanding of the executive audience. Results of the exercise will highlight risk concentrations and susceptible areas. It is important to tie stress test results to the risk appetite framework to provide the most impact and usefulness to the institution.
Although challenging, if done successfully, stress testing significantly promotes communication and risk awareness and develops a strong risk management culture.
