A tipping point for tougher stress tests

A tipping point for tougher stress tests

The evolution of regulatory stress testing has forced banks to develop increasingly complex methodologies. As a result, current stress testing processes may become unsustainable if the demands from senior management and regulators continues at pace.

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Harder to fail

Given the levels of capital accretion in recent years we would expect fewer banks to fail quantitative hurdles set by regulators except in the most extreme scenarios. However, stress testing remains a core regulatory tool to test individual and system-wide resilience and will continue to be used for internal and regulatory monitoring. This highlights a need for a discussion between banks and regulators on the balance of effort between internal and regulatory stress testing.

Complexity prevails

We would argue that the level of complexity in stress testing has risen to the point where the degree of effort required by institutions is not matched by the value they derive from the exercise. Despite this, the push to use stress test results to help set a firm’s individual capital requirements does cause management to use the tests as a capital tool, even if there is diminished value as seen in its application as a risk management and business planning tool.

Globally, regulators continually review their stress testing procedures in an effort to make the process more effective and remove some of the regulatory burden from institutions that are perceived to present a lower threat to the financial system. While these changes may make stress testing simpler this must be balanced with the value that banks derive from the tests.

Finding value

Currently the balance of effort is weighted toward the regulatory exercises. This is diluting the time and effort from the business available to support internal stress testing despite the value of results in the management of the business. We believe there would be value to banks’ internal management in the development of simpler but directionally robust top-down tools to understand performance in a greater range of scenarios covering a broader range of risks.

Recommendations

Given the prevailing trend for ever-stricter regulatory supervision, stress testing will continue to evolve. We believe a more coordinated and aligned approach to regulatory stress testing exercises would significantly lessen the burden on banks thereby releasing resources to focus on internal risk management.

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