Macro Stress Testing
Great event from PRMIA on Macro Stress Testing at Moody’s last night. A few quick highlights:
- The role of the regulators is now not only to be sure that banks have enough capital to withstand a severe downtown, but that the banks have enough capital once the downturn has happened.
- The Fed have a new whitepaper coming out in July on “Effective Capital Adequacy Process” that covers 7 different aspects from risk management foundations through to governance.
- CCAR stress tests are thought by regulators to be easier to understand (e.g. this happens we get this loss) rather VAR/risk sensitivities that do not capture tail risk.
- Hedges that do not behave as hedges under times of stress are a major area of concern.
- Assumptions of the stress tests such as the second half of 2008 occuring instantaneously to the trading book is not reasonable/representative but hard to come up with credible/pragmatic alternatives.
- One of the speakers put forward the following lists of positives about the stress tests:
- Restoration of market/public confidence in banks
- Determination of the appropriate levels of capital adequacy
- Understanding of risk profile
- Identification of tail risks
- Curbing of risk taking
- Incentivising behaviours
- Whilst banks and regulators are often in conflict over capital adequacy, banks do implement their own internal stress tests and do have a commercial interest in doing this well.
- One panelist said that “the best hedge is to sell”
- Some banks have switched accountancy standards to game capital requirements, and there was some later debate that Risk Weighted Assets were a controversial part of the calculations when analyzed against the NYU Stern V-Lab stress testing.
- There is a danger that CCAR and stress testing drives or becomes an industry in itself, which is not good for markets, the banking system or the economy as a whole.
- There was some debate about liquidity risk as it relates to solvency, and that it should be much more integrated with the stress tests. The panel expressed interest at the forthcoming CLAR stress tests and how it relates to CCAR.
- The panel thought that the Federal Reserve is effectively challenging each bank to understand its own balance sheet better than the Fed can.
- Given the state of systems and data management at many banks, this was a big challenge.
- The panel thought that more open access to the data regulators are collecting would be great for academics to analyze given some of the big data technologies available to analyze such large datasets.
- One speaker put forward that only a subidized industry such as banking could an industry afford to treat data so poorly.
Great event, knowledgeable speakers with strong opinions and good wine/food afterwards (thanks Moody’s!).
What are the dangers if CCAR and stress testing drives or becomes an industry in itself?
Hi Peter, others may have more specific views to add, but I think a self-defeating side effect of any regulation such as CCAR is conformity, where everyone iterates towards the same solutions to the same problems, ensuring many will be exposed to the same risks and that many will simply not looking for new scenarios. Take a look at this post plus the two posts referenced with in for some past ideas: http://xenomorph.typepad.com/xenomorph/2012/02/regulatory-dis-harmony-at-baruch-college.html