The financial crisis in 2008 set a fire under the banking industry. It took out many major players and could have led to more victims had some banks not been deemed “too big to fail”. However, from the ashes of the crisis grew the realisation of the importance of stress testing.
Stress testing is not a new phenomenon in banking, large international banks have been using internal stress testing since the early 1990s. However, since the financial crisis in 2008, there has been new legislation introduced looking at capital adequacy and the overall makeup of financial institutions. Regulations such as the Dodd-Frank Wall Street Reform Act, the Consumer Protection Act, and the Basel III regulatory framework, as well as an overall change in attitude to risk, has meant that there is an increased need for banks to use more rigorous stress testing.
Before we look at how stress testing is growing within the banking industry, we must first understand what stress testing is and what its uses are. Stress tests examine how the effect that potential large-scale shocks to the market would affect the capital position of the bank. Banks run stress test models for various severe, but plausible, scenarios such a major economic downturn. The results of these models enable banks to ascertain their capital position. This ensures that should said scenario occur, the banks have the capacity to withstand the crisis and still be in line with regulatory thresholds. Stress testing is also helpful from a general business perspective as it can be used to help determine the spread of the risk-free rate when pricing a loan as well as attaining the maximum possible loss from one day to another using value at risk (VAR).
The scar that the financial crisis has left on the industry has led to changes in regulatory thinking and attitudes to banks failure. Banks are no longer thought of as the untouchable entities that they were perceived to be pre-2008. Both banks and governments realise the importance of financial institutions as a business as well as their significance when looking at a country’s economy in a broader sense. Just like any other business, banks need to ensure that they can protect themselves from any scenario that could potentially put their solvency in jeopardy.
As a result of this change in outlook, supervisory authorities and central banks are continuing to devote more resources to enhance stress testing in regulated institutions with many supervisory stress testing exercises being carried out on a yearly basis. With this increased requirement and usage of stress testing, there has been a large evolution in the methodologies in recent years. This has resulted in stress testing become a much more accurate form of testing, therefore making it a much more useful tool. Hence, banks are increasingly looking to utilise the stress testing framework to help with risk management and are also used in the decision-making process when making strategic plans for the bank.
In the last 30 years, stress testing has gone from being simple exercises that had little impact on the policy decisions for banks, to having an integral role in banking regulation. Due to this stress testing is likely to continue to develop in the future and continue become an even more useful tool for policymakers within the Banking industry.
By Aaron Sutherland, a Vantage Point Consultant