Stress testing: From regulatory burden to strategic capability

October 26, 2016

Executive summary

The 2008–09 financial crisis triggered a significant increase in bank regulation and supervision around the world. Basel III was enacted to fortify regulation, introducing new capital buffers, increasing liquidity, and expanding the scope of risk management. Meanwhile, bank supervisors in Europe and the U.S. have shifted their focus toward trying to determine whether individual banks could survive another negative economic environment. They have put in place a series of stress tests to evaluate bank performance and capital under a range of challenging scenarios.

Whereas some banks perceive these increased regulatory demands as a burden, others have successfully leveraged the capabilities they have developed in response to this in their daily business activities and decision-making processes. Having analyzed the stress-testing capabilities of 27 banks throughout Europe and the U.S., we have found that banks that effectively use their stress-test findings in their day-to-day activities show higher performance across several key dimensions, including earnings strength, capital adequacy, and asset quality. This could be because fully embedding these insights enables banks to make more efficient use of capital, optimize their risk–return profiles, and intervene earlier and more effectively to mitigate downside risk.

However, to ensure an effective process and reliable results, banks must enhance their internal stress-testing capabilities. That means making certain that their results come from high-quality data, accurate models, efficient testing processes, and proper risk scenario coverage, and that they develop consistent processes for making use of those results. This report describes what banks can learn from their best-in-class peers that have incorporated the insights from stress testing into their risk management and business decision making.

We strongly advise all banks to adopt and develop these stress test capabilities to make the performance gains that many leading banks have already achieved.

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Regulatory pressure

Stress testing, both regulatory and internal, is aimed at providing a detailed picture of a bank’s current risk position, its key risk drivers, and the main sensitivities of its portfolio. These tests offer a comprehensive, forward-looking perspective on a bank’s full balance sheet and profitand- loss statements, giving the bank an assessment of the combined impact of all the risks it might face.

Because a bank’s assets and liabilities are generally highly diverse and complex, its aggregated risk profile is often not fully understood, especially by senior management or the board of directors. Stress testing can be a powerful tool to increase this understanding. By using the results to evaluate the bank’s business strategy, financial plans, and risk management, senior management can better assess tactical decisions, such as product pricing and divesting a portfolio, against strategic perspectives and targets.

Bank supervisors in different countries and regions, however, take different approaches to how they test their banks. (See “Stress-testing approaches vary.”)

Stress-testing approaches vary

Although some banks began developing their stress-testing capabilities before the financial crisis, at most banks the process was begun more recently and has been driven predominantly by supervisors. How supervisors in different regions approach the process, however, varies considerably.

The European Central Bank (ECB) and the European Banking Authority (EBA), for example, try to enhance financial transparency by ensuring that the results of their stress tests are comparable across all the banks they test. To achieve this, they apply a narrowly defined common adverse scenario and methodology to every bank. This one-size-fits-all approach, however, reveals little about the actual risk position of each individual bank.

In the U.S., the Federal Reserve Board (“the Fed”) tests each bank’s resilience to the particular risks it faces by asking banks to customize applicable models, scenarios, and methodologies to their particular situation. Each bank is expected to run stress tests against two defined scenarios — “adverse” and “severely adverse” — but the requirement goes beyond this on two counts.

First, each bank must design and run a customized “idiosyncratic risk” scenario based on its own specific portfolio, business model, and risks and vulnerabilities. This ensures that the process gives the bank’s board members and management an appreciation of the specific risks they face, and that the test results accurately reflect the bank’s degree of resilience in the face of adverse circumstances.

Second, to ensure quality and consistency, the Fed reviews the validity of the stress models, the accuracy of each bank’s data, and the degree to which the stress test results play a role in management decision making and risk management.

The Fed’s approach is widely acknowledged to be significantly more advanced than its European counterpart. Swedish supervisors, too, stand out for their historical emphasis on stress testing as a supervisory tool. More recently, supervisors in the E.U. have indicated that they will also start to look more deeply into how banks conduct their internal stress tests during the supervisory review and evaluation process, their annual review of capital requirements. At the same time, they plan to apply more scrutiny to the quality of the banks’ stress models and the degree to which the results influence management decisions.

Since banks have generally developed their internal stress-testing models in line with their particular regulatory requirements, they have in turn taken different approaches to how they conduct their internal tests, the models they use, and what they do with the results (Exhibit 1).

The impact of regulatory pressure

Exhibit 2 lays out the results of our survey regarding the degree to which 27 banks across Europe and the U.S. have succeeded in embedding their internal stress test results into their overall management practices. For the most part, banks in Europe conduct stress tests primarily to comply with regulatory requirements. As a result, these banks derive only limited insights into how the results should affect their business decision-making and risk management processes.

Geographic differences in stress-testing capabilities

Meanwhile, banks in the U.S. and in Sweden have leveraged their supervisors’ more complete and individualized approach to stress testing to perform stress tests more frequently than required, apply more enhanced scenarios, and use the results not only to comply with regulatory requirements, but also to influence their risk management and operational, financial, and strategic decision making. Several banks elsewhere in Europe have also chosen to go beyond their regulators’ requirements.

Don’t wait for the supervisors

Supervisors around the world will most likely push banks to further develop their capabilities and embed stress testing in their decision-making processes. Therefore, banks are strongly advised to adopt and develop such capabilities before they are required to do so. This is especially true of European banks: Having just completed their 2016 regulatory stress tests, they have some breathing room before the next round.

Banks that have not yet done so should push hard to improve their data quality, model performance, efficiency, and scenario flexibility. The investment required is only a small portion of the structural benefits they can capture. Banks that already have strong stress-testing capabilities should make the insights a key factor in their strategic and day-to-day decisions by broadening the scenario coverage of their stress tests and integrating the findings into their existing processes, including risk assessment, operational planning, and capital planning.

The benefits, both strategic and tactical, are real. Now is the time to move forward.


Stress testing: From regulatory burden to strategic capability