Stress-Testing in Financial Institutions: Selecting Appropriate Scenarios

OVERVIEW

The objectives of stress-testing should be clear to everybody involved, but experience shows time and time again that this is not the case. Provided there is a clear internal consensus about what is to be done and with what aim, a stress-test exercise can be invalidated or reinforced by the choice of scenarios that follows the initiation of the exercise. We go through the prerequisites for combing the potential future with no totems and taboos, and then highlight a few sources for scenarios. The sources can include the unfortunate history of other banks modified as appropriate, what could have happened but fortunately did not, and others as needed.

From the portfolio of candidate scenarios and their variations, we investigate what has to be done to be able to decide if further use is needed, to arrive at the main portfolio of scenarios that will guide a few critical actions. The reward for such an approach is that the set of scenarios will include the next crisis, therefore putting the bank in the best position to withstand the next turbulent times if not even thrive on them.

The objectives of stress-testing should be clear to everybody involved, but experience shows time and time again that this is not the case. Provided there is a clear internal consensus about what is to be done and with what aim, a stress-test exercise can be invalidated or reinforced by the choice of scenarios that follows the initiation of the exercise. We go through the prerequisites for combing the potential future with no totems and taboos, and then highlight a few sources for scenarios. The sources can include the unfortunate history of other banks modified as appropriate, what could have happened but fortunately did not, and others as needed.

From the portfolio of candidate scenarios and their variations, we investigate what has to be done to be able to decide if further use is needed, to arrive at the main portfolio of scenarios that will guide a few critical actions. The reward for such an approach is that the set of scenarios will include the next crisis, therefore putting the bank in the best position to withstand the next turbulent times if not even thrive on them.

WHY SHOULD YOU ATTEND?

Stress-testing, as practiced in most institutions, is much too often hijacked by regulatory necessity: to improve one’s standing for the authorities, or by reputational necessities: to reassure the public. A simple way to hijack a stress-test exercise is to use an inappropriate set of scenarios. Hence, it seldom turns out to be a useful exercise it can be for bank managers.

After going through the most typical ways to find irrelevant, innocuous, and other useless scenarios, we provide a few pointers on how a stress-testing exercise can be improved by a choice of scenarios, and provide a few criteria for finding and selecting appropriate scenarios.

LEARNING OBJECTIVES

• Regulatory requirements for stress-testing
• The managerial necessity for stress-testing
• The common wrong choices of scenarios
• Sources for scenarios
• Discarding and evaluating scenarios
• Potential hijacks of scenarios
• Using the selected scenarios for strategic risk management
• What an appropriate set of scenarios can bring

WHO WILL BENEFIT?

• Regulation & Compliance 
• Operational Units Managers
• Financial Institutions Advisory 
• Bank Supervision and regulation
• Financial Officers
• Risk Officers
• Internal Auditors
• Operational Risk Managers

SPEAKER PROFILE

Fred Vacelet is a Financial Risk Management Consultant and trainer with an international expertise in Risk Management methodological frameworks. His experience spans some 25 years, advising banks, software houses and others on risk management.

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