Many in the financial services industry equate “stress testing” with CCAR/DFAST. However, SR 12-7, “Supervisory Guidance on Stress Testing for Banking Organizations with More Than $10 Billion in Total Consolidated Assets,” is much broader.
Well-implemented scenario analysis (a.k.a “stress testing” since the Financial Crisis) provides an estimate of the magnitude of loss under certain circumstances, i.e., the scenario. Such analysis then permits the firm to allocate resources and take actions to either prevent losses (or reduce the propensity of their occurring) or develop contingency plans to minimize bad outcomes if an adverse scenario arises, i.e., manage risks.
SR 12-7 lists five principles of stress testing:
- Principle 1: A banking organization’s stress testing framework should include activities and exercises that are tailored to and sufficiently capture the banking organization’s exposures, activities, and risks.
- Principle 2: An effective stress-testing framework employs multiple conceptually sound stress-testing activities and approaches.
- Principle 3: An effective stress testing framework is forward-looking and flexible.
- Principle 4: Stress testing results should be clear, actionable, well-supported, and informed decision-making.
- Principle 5: An organization’s stress testing framework should include strong governance and effective internal controls.
If CCAR/DFAST is the extent of a firm’s stress testing, then, (a) the firm does not comply with SR 12-7, particularly Principles 1 and 2, and therefore, Principle 5; (b) there are likely deficiencies in overall risk management and data governance/systems that prevent implementation beyond CCAR; and therefore, (c ) any beneficial synergies between or among other exercises and CCAR/DFAST cannot be attained.
Executives should note, however, that conceptually-sound and well-implemented CCAR/DFAST loss forecasting models can be re-purposed for broader use, including other, more firm-specific scenarios.
Gaps, Gaps Everywhere!
In every case that we have seen, firms that do not stress testing beyond CCAR/DFAST have gaps in their overall risk management and data collection, retention, and aggregation. These usually exist because risk management–particularly identification and analysis–is hampered by a lack of analyzable data.
There is a huge difference between data systems for record-keeping and systems that store, transform, or manipulate data into analyzable and actionable information. Basic record-keeping systems don’t store the fields needed to differentiate among customers or instruments nor assess their performance and behavior in response to changing environmental factors, like economic conditions.
More comprehensive approaches consider additional scenarios and risk factors besides those included in CCAR/DFAST, and, therefore, certainly supplement the firm’s CCAR or DFAST exercise. However, such stress tests, which are required under SR 12-7, can also complement CCAR/DFAST. How? By providing objective and evidence-based analysis of the firm’s idiosyncratic risks, which then can be used to better understand the, say, portfolio’s behavior and justify overlays or adjustments to modeled loss results. For example, the Fed does not forecast oil prices, but understanding that coincident effects of low energy prices on the firm’s customers can and should be incorporated in loss forecasts.
Despite the phraseology, the intersection of CCAR/DFAST and non-CCAR/DFAST stress tests is not the empty set; instead, it is a richer, more rigorous understanding of the portfolio, which provides the opportunity for more effective risk management.
Such usage transforms CCAR/DFAST (and compliance with SR 12-7) into value-creating activities, rather than obligatory regulatory exercises. In fact, while we won’t do so here, one could argue that the managerial benefits of CCAR/DFAST–i.e., integrating methodologies and results into “daily” activities–can only be achieved through full compliance with SR 12-7, which would provide both broad and deep insights into the firm’s propensities and magnitudes of losses.