In a previous publication, COVID-19 implications for risk management, we provided an overview of important measures the financial industry needs to take to improve risk management and adapt to a COVID-19 environment. On the topic of comprehensive internal stress testing and simulations, we stated that:
“[Impact of COVID-19 on profitability, liquidity, and capital situation] needs to be considered in the internal comprehensive, multi-year stress-testing approach. This significantly revised stress-testing approach needs to be based on a revised risk modeling approach and capture multi-year effects not only on credit risk but also on other risk types (e.g. market risk, liquidity risk, operational risk). It needs to provide the complete view of the overall impact on the bottom-line of a specific institution.”
With this publication, we explore the topic further by describing the adjustments necessary for stress test methodologies in response to this year’s events. Our aim is to provide guidance and experience-based insights on the key aspects banks need to consider when revising their internal stress testing methodologies, processes and tools post-COVID-19.
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To adapt their stress testing in light of the COVID-19 pandemic, financial institutions urgently need to make the following five adjustments:
1. ADAPT MACROECONOMIC STRESS TEST SCENARIOS
Comprehensive stress tests have become an integral part of banks’ internal steering. While most adverse scenarios used in such comprehensive stress test exercises have probably previously ignored the risk of infectious diseases and their far-reaching impact on an interconnected global economy, the coronavirus pandemic represents a fat-tail risk that needs to be considered.
Regulators, research departments and risk managers need to refine their overall adverse stress test scenarios as well as the set of inverse stress test scenarios used to demonstrate banks’ resilience to future shocks.
We also expect that in many areas the granularity of macroeconomic forecasts needs to be adjusted, particularly for the “stress test parameter space” of the inverse stress tests to account for different impacts of such scenarios on different industries and countries.
Finally, macroeconomic scenarios need to be sufficiently complete, such that all relevant perspectives (business development, risk, profitability, liquidity etc.) can be derived.
2. INCLUDE CHANGES IN CUSTOMER BEHAVIOUR
Governments have put in place loan programs and similar measures to support businesses and individuals during the pandemic, helping them improve liquidity and reduce the financial burden. By granting extensive state-guaranteed loans, governments have created additional financial leeway for customers who have suffered in the crisis.
In addition, heterogenous industries and customer groups are recovering at different speeds, which in turn strongly impacts customer behavior – both on the credit side, where payment deferrals and loan drawdowns differ considerably, and on the liability side.
To adequately reflect the overall risks for the financial industry, the mentioned interdependencies between loan programs, specific industries, customer situations and customer behavior need to be taken into account in stress testing, as these will impact profitability, credit risk as well as operational and liquidity risks. This will significantly change the stress testing methodology for many banks as customer behavior has only played a minor role in stress testing and simulation to date.
3. INCORPORATE ADJUSTMENTS IN BUSINESS STRATEGIES
The economic impact of the pandemic on growth, employment and consumption is pervasive and will sooner or later be reflected in banks' risk, profitability and ultimately balance sheets. Moreover, as in previous crises, reliable diversification strategies have become important again during the coronavirus pandemic. Particularly in corporate and real estate portfolios, where losses can be much greater than in diversified private and commercial bank portfolios, a prolonged downturn and the formation of excessive risk concentrations may prove to be a serious threat for banks.
Understanding this paradigm shift is vital for banks, as it requires a fundamental rethink of business models. Depending on how the pandemic develops, banks may need to adjust their pricing, risk appetite and industry focus.
Such current or anticipated changes in business strategy also need to be reflected in the stress testing approach. Whereas traditional comprehensive stress testing often assumes an unchanged business strategy over the time horizon of the stress test exercise, the mentioned interdependencies need to be taken into account and modeled for stress tests going forward.
4. REVISIT STRESS TEST MODELS
The stress testing methodology includes different types of models - from macroeconomic models that link macroeconomic indicators to risk drivers, through the modeling of risk drivers, to detailed market and credit risk portfolio models from which, for example, provisions and losses can be derived.
These models are often based on historical data. Their applicability to unprecedented events such as the disruption of global supply chains and lockdowns may be limited. Furthermore, the assumed correlations within the models and between risk types typically break down in crisis (and recover afterwards at different speeds).
Risk managers must therefore review the applicability of their risk models, adjust existing parameters and, if possible, add the ones that are missing. When calibrating these parameters, they must also put a stronger focus on point-in-time models rather than on through-the-cycle approaches.
5. REVISE BANKS’ INTERNAL STRESS TEST METHODOLOGY, PROCESSES, AND TOOLS
All factors mentioned above need to be reflected in a bank’s overall comprehensive stress testing methodology. In most cases, we expect that the granularity of stress testing will need to be increased, incorporating significantly more differentiation between customer groups, industries, asset classes, etc. This will lead to challenges on the modeling side, i.e. the models mentioned will potentially need to be further refined, while on the data and tools side, the classical Excel-based stress test modeling is no longer be feasible in a more complex COVID-19 world.
We have mapped the necessary adjustments described (from 1 to 5) on the risk map below, indicating where the changes impact the overall structure of the comprehensive stress test.
COVID-19 risk map for banks’ comprehensive stress testing
TO RECEIVE YOUR PRINTED A2 POSTER, CLICK HERE.
The coronavirus pandemic represents an acid-test for banks’ internal stress testing. To prove their resilience to future shocks, banks must adapt, refine, and differentiate their internal stress test methodologies, processes, and tools. They need to rethink their business models and risk strategies (paying particular attention to economic sectors and credit volume limits), as well as considering customer behavior and its impact on various types of risk. Finally, banks will also need to review the applicability and calibration of their risk models.
Capco is uniquely positioned to help tackle the complex challenges ahead. Contact us to find out more about how Capco can help your financial institution enhance its stress testing methodology and processes and set up the required data management and analytical tools landscape. These provisions will help your firm adapt faster and more smoothly to the changing economic and regulatory landscape.
To help you understand what adjustments are necessary to optimize your stress testing under COVID-19, we have created the above risk map as a printed, full-color A2 poster. Request your copy here.
Dr. Olaf Clemens, Partner
M +49 172 746 7502
Dr. Martin Rehker, Managing Principal
M +49 174 334 6440