Stress Testing Is a Critical Tool in Risk Management: Community Banks Already Perform Stress Testing for Interest Rate Risk and Liquidity, but the Need to Test for Credit Risk, Too, Is Likely Not Far off. for All Banks, Certain Principles Apply
Clarke, Jim, The RMA Journal
Stress testing has been in vogue since the financial crisis of 2008, but the concept is not new to bank financial managers. Community banks have been stress testing their balance sheets for interest rate risk since at least 1996, and thrift institutions were testing as far back as the 1980s.
Only in the past four years has stress testing been extended and formalized to encompass liquidity and credit risk management. The crises faced by Bear Stearns and Lehman Brothers in 2008 were the impetus for liquidity stress tests introduced in 2009. Meanwhile, concern over systemic risk posed by the largest banks led to the introduction of credit stress testing.
In 2009, the Basel Committee on Banking Supervision proposed guidelines in a document that laid out general principles for stress testing. (1) Regulators have provided specific guidelines for interest rate stress tests, but they have been hesitant to articulate specific requirements for liquidity and credit risk stress testing.
The following general principles should apply to all stress tests:
Principle 1: A banking organization's stress-testing framework should include activities and exercises that are tailored to and sufficiently capture the banking organization's exposures, activities, and risks.
Principle 2: An effective stress-testing framework employs multiple and conceptually sound stress-testing activities and approaches.
Principle 3: An effective stress-testing framework is forward-looking and flexible.
Principle 4: Stress-testing results should be clear, actionable, and well supported and should inform decision making.
These principles were initially intended for institutions with consolidated assets of more than $10 billion, but they should apply to all banking organizations in all of the various stress tests they currently conduct or will be expected to conduct. These principles represent the regulators' views of best practices and form the expectations of examiners.
This article will apply these principles to interest rate and liquidity stress tests, which are currently required of community banks. It will also address credit risk stress testing, which will also be required for all banks, probably within the next two years.
Stress Testing of Interest Rate Risk
Stress testing for interest rate risk was formally introduced to all community banks in 1996 (2) with the release of the "Interagency Statement on Interest Rate Risk," which was updated in 2010. (3) Interest rate risk can be defined as the impact of a change in market interest rates on a bank's financial statements. Stress testing for interest rate risk is very specific in its requirements and outcomes.
In all testing, it is necessary to create events that would put stress on the bank's financial statements. The outcome is focused on the event's impact on a bank's capital or income. In this type of stress testing, the event is straightforward. Specifically, banks are required to simulate an increase and decrease in market rates of +/- 100 to 400 basis points.
In the opinion of this author, interest rate stress testing within community banking effectively addresses the principles developed by the Basel Committee. The first principle addresses the need for the stress-testing framework to include activities and exercises that are tailored to and sufficiently capture the banking organization's exposures, activities, and risks. In other words, the testing should reflect the complexity of the bank's balance sheet.
Interest rate stress testing is accomplished through sophisticated simulation models, and the guidelines provided by the Federal Financial Institutions Examination Council (FFIEC) focus on the robustness of these models. There are differences in the models' capability to handle complexity, however. Note that complexity is normally correlated to embedded options in the balance sheet, or negative convexity. …