Thursday 2 January 2014

Supervisory Stress and Scenario Tests: Does It Lead to Business Benefits?

I read a good question about stress and scenario tests: whether they are just a regulatory requirement or whether they are also a useful business tool.      

It is certainly a regulatory requirement in many jurisdictions, including the UK.  In my view, the supervisory application of stress testing is really re-writing regulatory requirements by formalising a new minimum level of capital which allows a bank to meet its minimum capital requirement after experiencing stress conditions.  I have written about this more extensively in my blog (here) following the publication of a paper on this subject by the Bank of England.  

If stress testing is a regulatory requirement, the next question is how it can be done so that the activity adds value to the business.  When I think about this, two aspects come to mind.  

Firstly, there is something about 'how' stress tests are done to add value to the business.  In this sense, there is something to take from the Bank of England paper.  The paper mentions examples of shortcomings that the UK supervisor has identified in banks' practices of stress testing, including the lack of Board engagement.  See my previous posting (link above) for a full list.  Interestingly, most of the shortcomings are related to governance.  It follows then that it is unlikely that banks will wish to derive value for their business if the governance has not been appropriate.

Secondly, there is something about 'what' is the source of business value.  Is the source of value the knowledge of the actual stresses?  Knowing the actual stresses prompts a question along the lines of 'so what'.  I believe fleshing out the answer to this question and identifying the management actions, planning them and seeking board approval would be the real value to the business.  Not surprisingly the paper from the Bank of England also stresses this aspect.  In a trading environment, the action could be adjusting appropriately the portfolio.  In a banking environment, this would need to be identified below the institutional level and may not be straightforward to identify.  

My view is that there may be an aspect of a 'catch 22' here.  If there is limited appreciation of the business value of stress testing then there will be limited incentives to improve the governance of stress testing to rely on them from a business perspective.  Supervisory intervention might then challenge this situation and as a by-product generate genuine business benefits.  

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