Moving beyond annual stress tests

Banks should consider ad hoc assessments as necessitated by the size, complexity and changes in the macroeconomic environment.

The last few years underscored how banks are directly impacted by a dynamic market that can be rocked by external shocks such as a global pandemic, regional warfare and other economic stressors.

The Federal Reserve conducts annual stress tests for banks, an analysis of whether the nation’s financial institutions can withstand a series of hypothetical economic shockwaves. The results of this year’s tests found that all 34 surveyed banks, which include U.S. global systemically important banks and other financial institutions with at least $100 billion in total assets, would experience substantial losses under the severely adverse scenario. However, it also showed that each organization would maintain capital reserves sufficient to absorb severe losses, keep capital well above the minimum requirement, meet their financial obligations and continue to lend to households and businesses.

This annual exercise remains useful, but financial institutions should move beyond regulatory requirements and recognize that stress tests should no longer be viewed as just a compliance activity. Rather, banks should consider undertaking regular ad hoc stress tests to assess new drivers and more general tests as necessitated by the size, complexity and changes in the macroeconomic environment.

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A more proactive approach can help banks manage significant events when they arise. While more regular stress testing will provide banks with a wealth of benefits, these processes will also be met with several expected challenges.

Building such a capacity requires an enterprising perspective that considers stress testing not only as an external compliance requirement but also as a strategic planning tool that complements an organization’s top-down forecasting processes. This requires alignment across all business units, which must unify to create stressed market conditions that they want to simulate their business against and proactively work through business plans to deal with such market conditions in a consistent manner.

Other challenges banks may face when incorporating stress testing into everyday processes include:

  • Working with systems, data sources and models that are dispersed and siloed;
  • Sharing datasets, coordinating processes and managing workflows via email;
  • Taking too much time to create a stress test to align to a specific business objective;
  • Adopting manually intensive processes to carry out impact assessments

By integrating stress test tools into various business processes, financial institutions can stay in command of the risk factors they are exposed to and understand various scenarios that could render the bank unviable. This would allow banks to test the strength of their assets and strategies to gain a better understanding of how their organization would handle such situations if they arose. Such meaningful integration can also improve regulators’ confidence in the banks’ risk management practices and bolster overall market perception.

What’s more, modern stress testing is often no longer based on standalone macroeconomic indicators, such as GDP and foreign exchange rates. Instead, banks are shifting toward executing driver-specific stress tests, similar to the climate change stress tests that regulators in the U.K. and Europe have mandated. This innovative view of stress tests can help banks to better assess business strategies, perform impact assessments under various market scenarios and understand the stress thresholds within portfolios and lines of business.

Ideally, financial institutions could conduct on-demand stress tests that leverage the same base data sets and calculation engines as their usual business processes with a holistic view of impacts across revenue growth assumptions, credit and liquidity impacts. Increasing the use of stress tests aligned to their business-as-usual processes can allow banks to pivot as required when the market swings in an unexpected manner or optimize planning for a slowly evolving market event.

When comprehensive stress testing can occur on-demand, firms can design playbooks for many scenario types. To protect themselves and maximize profits in an uncertain future, banks should leverage their technology resources to implement stress testing and scenario analysis as a fundamental part of their everyday business processes.

All three authors are at Oracle Financial Services: Jason Wynne is global vice president for modern risk and finance product development; Christopher Graham is master principal solution consultant; and Yugesh Madhivanan is principal product manager.