A “how to” guide for Stress Testing the ERM way

November 2012Ioannis Stamatopoulos

RiskMatrix

Dubai IT Conference

RiskMatrix 2

Agenda

» Stress Testing Pre & Post Crisis:– Stress tests as early warning devices

– The Regulatory response – lessons learnt

» Key Elements of an integrated Stress Testing Framework:– Scenarios

– Data

– Models

– Deployment Platform

» How we can help

RiskMatrix 3

Stress Testing Pre and Post Crisis1

RiskMatrix 4

Stress Tests as early warning devices4

“The banking system’s reported financial indicators are above minimum regulatory requirements and stress tests suggest that the system is resilient.

IMF, Iceland: Financial Stability Assessment – update, 19 August 2008”.

» Within two months, Iceland’s three biggest lenders had collapsed, leaving its economy in tatters

RiskMatrix 5

Regulators to the rescue5

RiskMatrix 6

6

Stress Testing: Lessons learnt

Definition :

A stress test is commonly described as the evaluation of the financial position of a bank under a severe but plausible scenario to assist in decision making within the bank

The financial crisis has highlighted weaknesses in current stress testing practices.

» Use of stress testing and integration in risk governance

» Stress testing methodologies

» Scenario selection

» Stress testing of specific risks and products

Source: BIS, Principles for sound stress testing practices and supervision, 2009

RiskMatrix 7

Stress Testing – In a nutshell

Senior Management Engagement

RiskMatrix 8

Key elements of an integrated Stress Testing Solution2

RiskMatrix 9

Stress Testing Programs require a range of scenarios and severities …

Weaker Economy

Healthier Economy

Baseline:Recession

S3:Double

Dip

1-in-10

S4:Severe

Double Dip1-in-25

Alternative Economic Scenarios

S2:Mild

Double Dip

1-in-4

S1:Stronger Recovery

1-in-4

EmergingMarkets

Hard Landing

SovereignDefaultShock

In line withRegulatoryGuidelines

Event-Driven

Simulation-Based

1:100 1:25 1:20 1:10 1:4 Forecast 1:4

RiskMatrix 10

…accurate forecasts on the impact of these scenarios on the Macro Economy…

1994

Q1

1994

Q3

1995

Q1

1995

Q3

1996

Q1

1996

Q3

1997

Q1

1997

Q3

1998

Q1

1998

Q3

1999

Q1

1999

Q3

2000

Q1

2000

Q3

2001

Q1

2001

Q3

2002

Q1

2002

Q3

2003

Q1

2003

Q3

2004

Q1

2004

Q3

2005

Q1

2005

Q3

2006

Q1

2006

Q3

2007

Q1

2007

Q3

2008

Q1

2008

Q3

2009

Q1

2009

Q3

2010

Q1

2010

Q3

2011

Q1

2011

Q3

2012

Q1

2012

Q3

2013

Q1

2013

Q3

2014

Q1

2014

Q3

2015

Q1

2015

Q3

0

20

40

60

80

100

120

140

160

180

Baseline ScenarioStronger Near-Term Rebound ScenarioMild Second Recession ScenarioDeeper Second Recession ScenarioProtracted Slump ScenarioBelow-trend Long-term Growth ScenarioOil Price Increase, Dollar Crash, Inflation Scenario

10

Oil Prices under different alternative scenarios

RiskMatrix 11

Performance data

» Delinquency Rates and/or CDRs

» Prepayment rate and/or CPRs

» Net Charge-off Rate

» Severity of Losses

Macroeconomic vectors

» Unemployment Rate,

(Un)Employment Growth

» Average / Index House Prices

» Government interest rate and 10yrs

bond rate

» Retail Sales Index

» Real GDP, Disposable Income,

Private Consumption

» Total Debt Service Ratio

Econometricmodel

Output vectors» Prepayments (CPR)

» Default (CDR)» Severity (LGD)

»All under alternative scenarios

… models to translate these scenarios into the key risk drivers…

RiskMatrix 12

… all integrated under the same roof

Economic/Regulatory scenarios(MEDC, internal bank scenarios, FED)

Business strategy(growth, risk appetite, target rating, M&A)

PD & LGD models

C&ICommercial RESMERetail

Translation engines

Market data

Interest ratesMarket pricesExchange ratesCorrelations

Translation engines

Balance sheet

Contractual / BehavioralAmortizing / New volumeCost of fundsNet interest income

Translation engines

Costs / Taxes

ModelingAllocation

Translation engines

Liquidity ratios• Liquidity coverage • Net stable funding ratio

Regulatory capital• EAD (Behaviors / New volumes)• Risk mitigation / Effective LGD• RWA (EAD, PD, LGD)• Countercyclical capital buffer

Economic capital• EAD (Behaviors / New volumes)• Risk mitigation / Effective LGD• EC (EAD, PD, LGD, Correlations)

Bank’s eligible capital• Common equity• Dividends / Retained earnings• Minority interests• Sub debt maturing / Issuance• Provisions / EL / Deductions

P&L forecasts• Net interest income• Costs• Credit losses

Performance indicators• RAR / EVA• RARORWA• RAROC

Bank’s target rating• Global bank scorecard

Data Analysis Tools Scenario Management User Workflow- - -

RiskMatrix 13

How we can help

An integrated and open stress testing solution that goes well beyond software, leveraging on our economic expertise, financial and economic data repository and modeling services

RiskMatrix 14

14

© 2013 Moody’s Analytics, Inc. and/or its licensors and affiliates (collectively, “MOODY’S”). All rights reserved. ALL INFORMATION CONTAINED HEREIN IS PROTECTED BY COPYRIGHT LAW AND NONE OF SUCH INFORMATION MAY BE COPIED OR OTHERWISE REPRODUCED, REPACKAGED, FURTHER TRANSMITTED, TRANSFERRED, DISSEMINATED, REDISTRIBUTED OR RESOLD, OR STORED FOR SUBSEQUENT USE FOR ANY SUCH PURPOSE, IN WHOLE OR IN PART, IN ANY FORM OR MANNER OR BY ANY MEANS WHATSOEVER, BY ANY PERSON WITHOUT MOODY’S PRIOR WRITTEN CONSENT. All information contained herein is obtained by MOODY’S from sources believed by it to be accurate and reliable. Because of the possibility of human or mechanical error as well as other factors, however, all information contained herein is provided “AS IS” without warranty of any kind. Under no circumstances shall MOODY’S have any liability to any person or entity for (a) any loss or damage in whole or in part caused by, resulting from, or relating to, any error (negligent or otherwise) or other circumstance or contingency within or outside the control of MOODY’S or any of its directors, officers, employees or agents in connection with the procurement, collection, compilation, analysis, interpretation, communication, publication or delivery of any such information, or (b) any direct, indirect, special, consequential, compensatory or incidental damages whatsoever (including without limitation, lost profits), even if MOODY’S is advised in advance of the possibility of such damages, resulting from the use of or inability to use, any such information. The ratings, financial reporting analysis, projections, and other observations, if any, constituting part of the information contained herein are, and must be construed solely as, statements of opinion and not statements of fact or recommendations to purchase, sell or hold any securities. NO WARRANTY, EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE OF ANY SUCH RATING OR OTHER OPINION OR INFORMATION IS GIVEN OR MADE BY MOODY’S IN ANY FORM OR MANNER WHATSOEVER. Each rating or other opinion must be weighed solely as one factor in any investment decision made by or on behalf of any user of the information contained herein, and each such user must accordingly make its own study and evaluation of each security and of each issuer and guarantor of, and each provider of credit support for, each security that it may consider purchasing, holding, or selling.