Bank stress testing needs to get real

banks need to stress test
Pete McIntyre, the liquidity expert

Written by Pete McIntyre

July 13, 2022

Banks and regulators are being urged to integrate real-time demands into stress tests and scenarios to gain powerful, novel insights and intelligence.

Since its introduction in the wake of the 2008 financial crisis regulated stress testing of banks has developed into an established feature of the industry globally. And while it has undergone periodic updating to reflect new realities and concerns, there is growing concern the exercises are driving banks to behave defensively (see BoE Discussion Paper DP1/22) because they focus on spot LCR and do not integrate one vital ingredient: real-time data.

Nick Jepson, chief client officer at real-time treasury software expert Planixs, is among those arguing strongly for regulators and banks to pay more heed to the need for real-time data in stress testing and resolution readiness. He points out the world has moved on significantly since the first stress tests were carried out in 2009 by regulators in the US and Europe.

There has, for example, been a payments revolution over the last ten years, and digital currency has arrived with CBDCs very much on the horizon. On the economic front, after a relatively benign operating environment over the last ten years, inflation and volatility are back with a vengeance.

Jepson adds: “Based on reactions to the conflict in Ukraine, we are looking at emerging trading blocs that could pose treasurers and CFOs big new questions about exposure to certain countries over the coming years. Suddenly things have become much more unpredictable, and as we have just experienced recently during the pandemic, real-time visibility for organisations is crucial. It should feature prominently in stress testing too.”

Compounded scenarios

While US and European regulators had their first stab at formally stress testing banks in 2009, it wasn’t until 2018 that the Basel Committee on Banking Supervision issued the final, revised version of its stress testing principles, creating an international standard for regulators to use when crafting regulations about how much capital banks need to put aside to guard as a bulwark against the financial and operational risks they face. Over the years stress testing has evolved into a critical element of risk management for banks as well as a core tool informing regulatory policy.

The tests themselves focus on a few key areas, such as credit risk, market risk, and liquidity risk, to measure the financial health of banks in a crisis. In the UK, for example, the BoE presents scenario ideas to banks and other institutions to develop further to suit their particular business model and risks. The key requirement from the BoE for all scenarios stress tested by institutions is they must be sufficiently “serious, severe, and plausible” so that they represent a strong challenge for the business.

Historical crises such as the 1987 Black Monday stock market crash, the 1997 Asian crisis, and the 2008 financial crisis have all served as a basis for developing stress testing scenarios in the past.

More recently, Covid provided the BoE with the basis for its 2021 solvency stress test scenario for institutions. The BoE described the scenario as a “severe path for the economy in 2021–25 on top of the economic shock associated with the Covid pandemic that occurred in 2020”.

It features a ‘double-dip’ recession and an intensification of the macroeconomic shocks seen in 2020. Versus the pre-Covid baseline, the scenario also implied a cumulative three-year loss of 37% of 2019 UK GDP and 31% of 2019 world GDP; UK residential property prices slumping by 33%; and UK unemployment rising by 5.6 percentage points to peak at nearly 12%. Firms were required to use an end-2020 balance sheet as the starting point for their stress test. The Bank of England also orchestrates the Liquidity Biennial Exploratory Scenario stress testing exercise that recently looked at a scenario impacting major UK banks simultaneously.

Reporting on the results of the test, the BoE found the major UK banks to be resilient to its 2021 scenario and did not require any of the banks to strengthen their capital position as a result of the exercise. Jepson says that a scenario where real-time data would provide insights and stress modelling could increase confidence for banks to reduce their high quality liquid assets (HQLA) and drop below 100% liquidity coverage ratio (LCR) during extreme stress and the subsequent recovery period.

Data quality is key

Jepson says that while scenarios can be tricky to fashion two further elements are vital for effective stress testing: good quality stress testing models and accurate and timely data. “Understanding the capabilities of stress testing models, their limitations, and the impact of model uncertainty on banks’ stress testing results are critical as is the availability of reliable and relevant data,” he says.

“Historically, financial firms have focused on being compliant with Basel rules down to the letter. However, there is a need for firms to now consider taking a more indicative approach, utilising better forecasting and modelling techniques and real-time data collection and analysis to ensure they are prepared for crises.”

Jepson says the principles of stress testing set out originally by Basel were effectively an agreed set of targets that a majority of institutions thought they could achieve at the time. Nowadays it is expected that all major firms have the capability to address them. “My view is that the stress test parameters that flowed from those principles have become almost the minimum that a financial institution should be aiming to be able to do well,” he says. “Regulators are now wanting to compound scenarios, add one to another [as with the BoE’s intensified Covid scenario for 2021], to create more complex scenarios and combinations that more fully demonstrate firms’ capabilities. As that trend develops it will only further reveal the limitations of current regime. What you really want to be able to do is draw innovative insights from stress modelling and testing, not just do it mechanically because you’re told to do it.”

Real-time momentum

Jepson says there are some enlightened regulators who are thinking in a more constructive and challenging way about stress testing. Within leading banks themselves, some have already started to look at the challenges and opportunities more compounded, complicated and agile scenarios may present. “The big question with all this, however, is still whether the data used is timely enough because a lot of stress testing is not done with anything like real-time information.

“When stress testing, regulators and banking supervisors really should also be assessing firms’ capabilities in command and control to react in short order to scenarios exposed to changing real-time information.”

Currently, the timescale for organisations to pull together essential balance sheet data needed for stress testing ranges from days to weeks, with leading banks generally working on a daily basis. Firms, however, are beginning to look for much more: “At Planixs we have ongoing conversations with clients who are looking to improve their intraday intelligence and, ideally, achieve real-time insights 24/7 because they know that when major dislocations and disruptions occur they do so really fast.”

Game changing technology

Ten years ago, it might have been hard for Jepson to realistically back up his call for real-time interrogation of data by banks but thanks to innovation and advances in technology, he believes it is now an entirely justified and necessary expectation. Planixs’ own flagship treasury management software Realiti, for instance, features a suite of modules that can capture, control, and optimise a firm’s intraday cash, collateral, and liquidity positions in real time.

Jepson says one of the biggest benefits of solutions like Realti is that they offer interactive and intuitive interfaces to simplify the user experience.

“You can have all the clever scenarios and data capturing and crunching in the world, but you have to be able to analyse the output effectively and quickly to support rapid response by the organisation,” he says. “User-friendly visualisation and presentation techniques are essential for that. Some in the organisation may prefer tabulated numerical formats, others may be comfortable with pictorial representations.”

Jepson notes that solutions like Realiti are not just about speed of data processing; they are also about making it easy for information to be shared rapidly across the organisation, presented in the user’s preferred format so that rapid insights can be gained.

Based on conversations with banking clients and other financial services players, Jepson does not believe it will be too long before regulators begin to push hard for intraday or real-time liquidity monitoring by major firms in their jurisdiction. “The momentum behind real-time is building anyway, and I don’t think it’s going to be five years and another bunch of Basel discussions beforehand. It is something people really need to think about now,” he says.

“Certainly from discussions I have had with our clients, it is clear they want to find a way to continue to be ahead of everybody else. As such it’s not just a treasury matter, it’s a C-suite and boardroom level issue. They should all be demanding to see their organisation move to real-time, using leading edge technology to provide them with valuable new insights and intelligence to drive strategy and decision making. And when stress events occur, they need real-time visibility of their recovery, their client’s health and the status of the liquidity exosystem.”


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