Stress Testing

EU Stress Testing from a Bank
Perspective
Stress Testing 1-Day Conference
Manuele Iorio, Senior Director Advisory Services
April 25th, 2014
Agenda
1. Regulatory background
2. Stress Testing in Europe
3. Enterprise Wide Stress Testing
2
1
Regulatory background
Stress Testing Lessons from Aftermath of the Crisis:
Observations from the Basel Committee
“Events of 2008-present in global financial markets clearly indicate the need for a more robust,
flexible and forward-looking stress testing framework for credit portfolios”
“Senior management’s involvement is critical in ensuring appropriate use of stress testing in
bank’s risk governance and capital planning. Banks that fared well in the crisis had senior
management take an active interest in the development of stress tests and making strategic
plans based on the results”
“Stress testing can no longer be isolated mechanical exercises by different business lines
that are hard to interpret, non-cohesive and strategically non-actionable”
“In most instances, stress testing frameworks were not flexible enough to respond quickly
as the crises evolved. Frequent (e.g. quarterly) updating of scenarios is critical for
understanding changing risk profile”
Basel Committee
4 4
Key steps of the Comprehensive Assessment (CA)
1. Supervisory
Risk Assessment
Quantitative and qualitative analysis to identify the highest risk
exposures of those banks under SSM supervision. It will include risk
such as liquidity or leverage of a bank, maturity transformation etc.
2. Asset Quality
Review
Examination of a broad range of portfolios selected
on a risk-based approached followed by a data
integrity validation, on-site reviews etc..
3. Stress Test
Stress test in collaboration with
EBA based on the work of the
stages 1 & 2. The stress test will
include banks outside the SSM.
5
The ECB Comprehensive Assessment of the EU Banking System
Encompasses Three Main Work Streams
2013
2014
Q4
Q1
Q2
Q3
Risk
Assessment
Asset Quality Review
Stress Testing
– Supervisory
judgments on key
risk factors, such
as liquidity,
leverage and
funding
– Assessment of data quality,
asset valuations,
classifications of nonperforming exposures,
collateral valuation, adequacy
of provisions
– Forward-looking view of banks’
shock-absorption capacity
under stress conditions
– Quantitative and
qualitative
analysis
– Covering credit and market
exposures, following a riskbased targeted approach
– Credit risk, market risk,
sovereign risk, securitisation
and cost of funding to be tested
– Targeted portfolios represent
at least 50% of total RWA.
Material non-EU portfolios
and level 3 assets within
scope
– 3 year stress test (2014-16)
with static balance sheet
projection
Source: ECB and EBA 2013; 2014
Q4
SSM goes
live
– Minimum thresholds: CET1
Baseline ≥ 8% and CET1 Post
Stress ≥ 5.5%
6
Key Milestones of the ECB Comprehensive Assessment
ECB Comprehensive Assessment
2013
Work Stream
Dec
2014
Jan
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
1. Supervisory 1.1 Comprehensive risk assessment
Risk
Assessment 1.2 Quantitative and qualitative analysis
2.1 Portfolio selection
- Banking Book
- Trading Book – Level 3 Assets
2. Asset
Quality
Review
2.2 Execution
14 Mar - Completion of Loan tapes
- Preparations and Data Collection
31 Mar - AQR Methodology Release
- On-site review of files
- Collateral & RE valuation, specific and
collective provision analysis
- Level 3 assets review
- Risk Weighted Assets
2.3 Quality Assurance and Results
3.1 Scenario Selection
30 Apr - Scenario selection
3.2 Model development & validation
3. Stress Test
3.3 Loan loss forecasting
3.4 Pre-provision profit forecasting
3.5 Aggregation and analysis
3.6 Quality Assurance
4. Final Regulatory Challenge (ECB, EBA and NCAs)
5. ECB Decisions and Disclosure
31 Oct – Results Disclosure
7
EBA Stress Test Exercises Compared – 2011 vs. 2014(*)
2011
- Focus was on credit and market risks
- Took into account the evolution of funding costs, particularly the effect
of sovereign stress
Risk Areas
Treatment of Sovereign Exposures
- Securities held in the trading book took valuation haircuts owing to a
widening of credit spreads
- Securities held in the banking book took provisions based on
scenarios of ratings agency downgrades
Two years (2011 and 2012)
2014
- Will Focus on a wider range of risks, including credit risk, market risk,
sovereign risk, securitization and cost of funding
- National regulators may include additional risks (e.g., sector-specific
or conduct risks)
- Securities held in the trading book and as available for sale (AFS) will
be marked to market, with losses realised immediately (trading book) or
at the supervisors’ discretion (AFS book)
- Securities held to maturity will be subject to a shift in the risk weights
based on internal model assessments of changes in credit risk
Three years (2014-16)
Time Horizon
91 banks, covering 65% of the European Union’s overall banking system 124 banks, covering at least 50% of the national banking sector in each
assets, and at least 50% of the national banking sectors in each EU
European Union member state (including four UK banks, 11 French
member state (including four UK banks, four French banks, four Italian
banks, 15 Italian banks and 23 German banks)
banks and 12 German banks)
Sample of Banks
Balance Sheet Assumption
Static balance sheet, zero growth and constant business mix
assumption. Exceptions for banks under a European Commissionmandatory restructuring plan
Same
Core Tier 1, Basel 2.5
Common equity Tier 1 (CET1), Basel III additional Tier 1 and Tier 2
instruments converting into CET1 will be reported separately if the
conversion trigger exceeds the CET1 ratio in the adverse ratio
Adverse scenario: 5.0%
Baseline scenario: 8.0%
Adverse scenario: 5.5%
Definition of Capital
Pass Rates
Source: European Banking Authority
(*) Moody’s Investor Service, “Sector Comment - European Banking Authority Stress Test Details Are Credit
Positive for Banks”, February 06th 2014
8
The Core Requirements of Stress Testing Regulations are
substantially Aligned Across Regions
Eurozone
United Kingdom
United States
EBA / ECB / NCA 1
BoE / PRA1
Federal Reserve
Largest Eurozone/Significant
Banks (approx. 128 banks)
Largest UK Banks &
Building Societies
BHC&FBO6; assets > than
$10bn (DFAST), $50bn (CCAR)
Data Requirements /
Reporting
Historical/AQR Data – Core
(ADC, TR, CSV) & Additional
(CSV) Templates2,3
FDSF4 – Historical, Year-End
Data & P/L Projections
FRY Reports – A/Q/M Data;
P/L Projections
Modeling Approach
Bottom-Up & Challenger/TopDown; Firms’ Own Models
Bottom-Up /Granular; Firms’
Own Models
Bottom-Up; Firms’ Own
Models; Dynamic Projections
Scenarios
Regulatory Baseline, Stress
Scenario
Common Stress, Bespoke Firm
Stress, Common Baseline
Baseline, Adverse, Severely
Adverse; Firms’ Scenarios
Disclosure
Public Disclosure of Results
(Bottom-Up)
Public Disclosure of Results
Public Disclosure of Results
Frequency
Annual (2009-2011 EBA); 2014
(ECB)
Annual
Annual (regulator-led);
semiannual (bank-led)
Recapitalization Plan
Input Capital Adequacy CRDIV &
firms’ PRA buffer; FPC Tool5
Input Capital Plan, Approval by
Fed; Dividend Planning,…,etc.
Regulatory Body
Coverage
Corrective Measures /
Use of Outputs
Source – Moody’s Analytics
1.European Banking Authority (EBA), European Central Bank (ECB), National Competent Authorities (NCA), Bank of England (BoE), Prudential Regulation Authority (PRA)
2.Asset Quality Review (AQR)
3.Advanced data collection (ADC), Transparency (TR) and Calculation, Validation & Support (CSV) Templates
4.Firm Data Submission Framework (FDSF)
5.Financial Policy Committee (FPC); Capital Requirements Directive IV (CRD IV)
6. Bank Holding Companies (BHC), Foreign Banking Organizations (FBO)
9
The BCBS Principles for Effective Risk Data Aggregation and Risk
Reporting Are Aimed to Enhance Banks’ Data Architectures
14 Principles for Effective Risk Data Aggregation and Risk Reporting
Governance and Architecture
Risk Reporting
• Principle 1: Governance
• Principle 7:Accuracy
• Principle 2: Data architecture and IT architecture
• Principle 8: Comprehensiveness
• Principle 9: Clarity and Usefulness
• Principle 10: Frequency
• Principle 11: Distribution
Risk Data Aggregation
Supervisory Review
• Principle 3: Accuracy and Integrity
• Principle 12: Review
• Principle 4: Completeness
• Principle 13: Remedial Action and Supervisory
Measures
• Principle 5: Timeliness
• Principle 6: Adaptability
• Principle 14: Home/Host cooperation
BCBS Principles for effective risk data aggregation and risk reporting , Jan 2013
Implementation by 2016
10
2
Stress Testing in Europe
Overview of Stress Testing at Industry Level
» AQR has revealed quite painful in terms of data production and verification, loan and
collateral assessment. In many cases the effort has been carried out with a huge
manual effort
» EBA Stress Testing exercise is more granular and prescriptive with respect to the past,
and has increased its coverage in terms of Banks and assets. This means however that
many banks will participate to the exercise for the first time (e.g. second tier banks).
» From the Industry both exercises are based on assumptions and data that are in most
cases useless from an internal perspective. Hence the exercises are only perceived as
regulatory burden
» Stress test governance shows in many cases not appropriate with respect the risk
management best practices. Stress test is not often perceived as a key risk
management tool.
» IT infrastructure, models and data availability prove to be a clear limitation in these type
of exercises. Many Banks have already started investing in stress testing capabilities.
The main objective is being able to perform Enterprise Wide Stress Testing.
12
Stress testing – Current Status (1/2)
1
Governance
2
Process &
Reporting
» Strong efforts to ensure coordination across finance, treasury and risk
groups
» Relevant obstacles for having a timely communication through chain of
command as C-suite and senior management are engaged in scenario
definition and results review
» Boards often have a limited knowledge of Stress testing
» Substantial lack of transparency of the overall process
» Stress testing not appropriately used for Bank steering
» Need for a clear integration of stress testing with forecasting/planning
» Difficulty in handling an increasing frequency of stress testing requests
» Lack of harmonization between regulatory, stress testing methodology
and accounting/planning
» Ex-ante and ex-post analysis in some cases even not possible (i.e.,
backtesting)
» Not easy auditability of results
» Reporting process is not fully automated and not flexible enough to cope
with different template requests
13
Stress testing – Current Status (2/2)
3
» Infrastructure is often based on spreadsheets and therefore not well
suited for Stress testing purposes
Technology
» Manual processes constraints have relevant impacts on:
- Frequency of stress testing
- Reconciliation (FINREP, COREP) and controls
- Ability to analyze results
» Given the limited resources Banks struggle with competing priorities:
- Need for long term infrastructure planning and enhancements
- Short-term stress tests timeline
4
Models & Data
»
»
»
»
»
Methodologies continue to evolve and not all Institutions are investing
Emphasis on greater granularity
Consistency of loss estimations and new business methodologies
Quantifying “unknown unknowns” (e.g. model risks)
Routine models instead of an integrated framework
14
BCBS Principles Progress report: IT infrastructure and
Data are still a problem
The difficulty in
complying with the
principles related to IT
infrastructure and
governance is more
evident while examining
the worst scores.
Worst
Ratings
15
BCBS Principles Progress report: The most critical
principles
Principle 2 - Data architecture
and IT infrastructure
Principle 3 - Accuracy and
Integrity
Principle 6 - Adaptability
A bank should design, build and
maintain data architecture and IT
infrastructure which fully supports its
risk data aggregation capabilities and
risk reporting practices not only in
normal times but also during times of
stress or crisis, while still meeting the
other Principles.
A bank should be able to generate
accurate and reliable risk data to meet
normal and stress/crisis reporting
accuracy requirements. Data should
be aggregated on a largely automated
basis so as to minimise the probability
of errors.
A bank should be able to generate
aggregate risk data to meet a broad
range of on-demand, ad hoc risk
management reporting requests,
including requests during stress/crisis
situations, requests due to changing
internal needs and requests to meet
supervisory queries.
Challenges :
Challenges :
Challenges :
– Centralization / standardization
– Data control responsibilities
throughout the data life cycle
– Completion and rollout of “risk
data” modules
– Inadequate IT systems,
including both source data
systems and aggregation
engines
– A level of dependency on
manual processes
– A lack of group-wide policies
– Heavy reliance on manual
workarounds, limited capabilities
to meet ad hoc requests and
adopt Internal / external
changes, and inflexible systems
and processes
16
3
Enterprise Wide Stress Testing
Benefits for Financial Institutions – Enterprise Wide Stress Testing
Frameworks
 Enables automating and streamlining the stress testing calculation and reporting process for
group-level and strategic analysis
 Helps to overcome limitations in the silos-based stress testing models and insufficient data
for bottom-up approaches; facilitate the risk appetite definition, analysis and quantification
 Enables board, senior management, risk and business units to proactively create
contingency action plans/resolution plans and make strategic decisions for risk
mitigation in the event of actual stressed conditions

Capital planning, allocation, & forecasting, and living wills: Raise capital through stock
issuance or balance sheet management, awareness of hedging necessities, etc.
 Allows appropriate pricing of risk (benign economic conditions and increased risk appetite
generally leads to under-pricing of risk) and help setting informed risk limits
 Adds to shareholder and market’s confidence; increase returns for shareholders
 Addresses & facilitate meeting regulatory requirements
 Frequent updating of stressed scenarios helps understanding the evolving nature of risk in
the business for strategic planning (e.g. economic cycle, mergers, acquisitions, future
regulations…)
 Synergies and reduction of costs (unified IT infrastructures, IT maintenance, less usage of
resources for data preparation)
18
The Industry’s Response Focuses on Enhancing the Strategic
Planning & Forecasting Process using Stress Testing
•
Forecasting dividend
policies
•
Reverse Stress Testing
•
RoE/RoA
analysis/projections under
scenarios/strategies
•
Budgeting planning
AQR &
Balance
Sheet
Reviews
Dividend
Planning &
Budgeting
•
Data quality and integrity
•
Harmonized NPLs and RWAs definitions
Strategic
Planning &
Forecasting
•
Regulatory and internal driven
scenarios
•
Strategic planning
•
What-if analysis
•
Inclusion on the living wills
•
Quantify contingency planning metrics
•
Linkage stress testing to capital plan
•
Dynamic balance sheet forecasting
•
Pre-provision net revenue forecasting
•
Margins & Volumes
•
M&A activity
Stress Testing
•
LCR forecasting
•
Funding projections
•
Liquidity stress testing
•
HQLA optimization strategies
Capital
Planning &
ICAAP
Liquidity
Planning &
Management
Risk Appetite
•
Growth strategy, M&As, deleverage
•
Setting risk limits & RAROC pricing
•
Capital allocation
19
An example of architecture to provide an Integrated
Stress Testing
Bank Source Systems
External Data
Market,
Liquidity
and Credit
Data, P&L and
Planning
Business Requirements
Unified Models
&Simulation Scenario
Regulatory Reporting
and Profitability at
Consolidated and
Sub‐consolidated level
Data Quality Checks
Reconciliation
Adjustment & Audit
ETL
Platform
Scenario Data
Results
Historical
Data
Series
Workspace
Calculation
Servers
Web Based Access
for broad range of users
Workspace
- Risk Indicators Dashboards
- Counterparty Search
- Audit and Variance Analysis
Data
Mart
Workspace
Scalable Pool of
computer resource ,
reducing calculation time
Regulatory Audit, Group Level.
Models Back Testing and Approval
20
Stress Testing Affects the Balance Sheet
Multiple Business Practices are Impacted. Requirement: Integrate Processes
Performance
Management
Industry Concerns:
Improved operational control(s)
through automation
»
Auditability & Transparency
»
»
Return on Investment
»
Linkage to ERM
»
Leverage existing spend
ALM/Treasury
» Profit before Impairment
losses
» Integration
» IRR/ALCO
» Discretionary books
Persistence
»
Budgeting / Plan
» Capital planning
» New business mgt
» Scenario mgt
» Distributed; Use-test
Stress-Testing
» Regulatory driven
»
Non-interest income/expense
» Internal use
»
Scenario Planning and
Maintenance
»
»
Volume, Rate, and Credit
Planning (distributed)
»
Scenario dependent base
runoff
Regulatory Reporting
Internal – Capital Planning
»
Profit Before Impairment
Losses
»
Budgeting/Planning
»
Profitability
»
ICAAP
» RAROC/ROCAS
» Risk Appetite Framework
» FTP/Profitability
»
Push-down through planning
and budgeting
»
Returns on capital before and
after stress
»
Credit adjusted NII
»
Reverse stress-testing
»
Dynamic balance sheet and
income statement
»
Risk Appetite Framework
»
Profitability analysis
»
Accurate pro-forma regulatory
and economic capital
»
Economic capital (full
integration)
»
Interest rate risk
»
Economic and market valuation
»
Liquidity risk
»
Net income
21
Institutions are Implementing a Workflow-Based
Collaboration to Streamline The Stress Testing &
Strategic Planning Process
Econometrics models, Risk Management & Finance Functions
Scenario Management
Business
Process
Econometric
Forecast
Budget &
Policies
Risk &
Profitability
Management
Mitigation and
Alignment with
Strategy
Technological Framework
Customizable
workflow, tasks
& data model
Customizable
Formula
Manager
Quick
Turnaround
User
interaction
Reporting
Dashboard
Audit
Alerting
&
Monitoring
Automation using a centralized Enterprise Wide Stress Scenario Management Platform
22
Improving Systems – A Fully Auditable System and
Granular Data are A Necessary Condition on Stress
Testing
Results are auditable only if inputs and
Input
granularity
• Country
• Industry
Macro
Eco
Variables
system provide the finest level of
granularity
» Business Organization dimensions
– Country, Business Units, business Line
– Channel, transaction type
• Currency
• Interest Rate
» Counterparty dimensions
Market
Data
Forecast
– Client Segment , Industry sector, rating
» Product Origination & Marketing
– Product types
• Business Unit
• Product Line
– Commitment Policies
Budget
» Guarantees & Collateral
– Collateral Guarantee type
– Valuation & LGD measurement
Output
Analytics
– LTV policies
23
About Moody’s Analytics
Moody’s Analytics Integrated Capabilities Help You
Achieve Your Credit and Risk Management Objectives
Training &
Certification
Credit Research &
Risk
Measurement
Structured
Analytics &
Valuation
Economic &
Consumer Credit
Analysis
Enterprise Risk
Management
25
25
Moody’s Analytics is Recognized as a Leader in Risk
and Regulatory Solutions
www.moodysanalytics.com
26
26
Our integrated capabilities fall into five areas of
expertise that address specific needs
Economic &
Consumer
Credit Analytics
Credit Research
& Risk Measurement
Training &
Certification
Structured Analytics
& Valuation
Enterprise Risk
Solutions
Outsourcing
Solutions
27
Moody’s Analytics Enterprise-wide Stress Testing Solutions
Stress Testing &
CCAR/DFAST
Model Development
Software
Implementation
Process Engineering
CCAR, Governance,
Policy & Gap Analysis
Model and Parameter
Estimation
Private
PDs
Installation, Database
setup, Customization
Workflow & Credit
Process Design
Regulatory & Audit
Support
Ongoing Services
Model Validation,
Benchmarking and IT
review PDs
Private
Training, Custom data
feeds and model hosting
Advisory & Implementation Services
Credit Assessment &
Origination
Economic Capital &
Portfolio Management
Basel I, II & III
Insurance Risk &
Solvency II
Asset & Liability
Management
RiskOriginsTM
RiskFrontierTM
RiskAuthorityTM
RiskIntegrityM
RiskConfidenceTM
Via DIS
Enterprise Risk Management Platform - RiskFoundation
Administrative
Console
Customization
Toolkits
Business
Reporting
Grid Computing
Scenario
AnalyzerTM
TM
TM
Regulatory
Reporting
Optional
Financial & Risk Datamart
Data & Models
Spreading & Internal
Ratings
RiskAnalystTM
Consumer
C&I
CreditForecastTM
CreditEdgeTM
CreditCycleTM
RiskCalcTM
CRE
LGDs
Ratings
CMM®
LossCalcTM
Moody’s Rating
Delivery Service
C&I
28
moodys.com
Manuele Iorio
Senior Director
Advisory Services
manuele.iorio@moodys.com
29
© 2014 Moody’s Analytics, Inc. and/or its licensors and affiliates (collectively, “MOODY’S”). All rights reserved. ALL INFORMATION CONTAINED HEREIN IS PROTECTED BY
COPYRIGHT LAW AND NONE OF SUCH INFORMATION MAY BE COPIED OR OTHERWISE REPRODUCED, REPACKAGED, FURTHER TRANSMITTED, TRANSFERRED,
DISSEMINATED, REDISTRIBUTED OR RESOLD, OR STORED FOR SUBSEQUENT USE FOR ANY SUCH PURPOSE, IN WHOLE OR IN PART, IN ANY FORM OR MANNER OR
BY ANY MEANS WHATSOEVER, BY ANY PERSON WITHOUT MOODY’S PRIOR WRITTEN CONSENT. All information contained herein is obtained by MOODY’S from sources
believed by it to be accurate and reliable. Because of the possibility of human or mechanical error as well as other factors, however, all information contained herein is provided “AS
IS” without warranty of any kind. Under no circumstances shall MOODY’S have any liability to any person or entity for (a) any loss or damage in whole or in part caused by, resulting
from, or relating to, any error (negligent or otherwise) or other circumstance or contingency within or outside the control of MOODY’S or any of its directors, officers, employees or
agents in connection with the procurement, collection, compilation, analysis, interpretation, communication, publication or delivery of any such information, or (b) any direct, indirect,
special, consequential, compensatory or incidental damages whatsoever (including without limitation, lost profits), even if MOODY’S is advised in advance of the possibility of such
damages, resulting from the use of or inability to use, any such information. The credit ratings, financial reporting analysis, projections, and other observations, if any, constituting part
of the information contained herein are, and must be construed solely as, statements of opinion and not statements of fact or recommendations to purchase, sell or hold any
securities. NO WARRANTY, EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR
PURPOSE OF ANY SUCH RATING OR OTHER OPINION OR INFORMATION IS GIVEN OR MADE BY MOODY’S IN ANY FORM OR MANNER WHATSOEVER. Each rating or
other opinion must be weighed solely as one factor in any investment decision made by or on behalf of any user of the information contained herein, and each such user must
accordingly make its own study and evaluation of each security and of each issuer and guarantor of, and each provider of credit support for, each security that it may consider
purchasing, holding, or selling.