Everything financial services must know about sufficient stress testing practices

The annual PricewaterhouseCoopers’ (PwC) Financial Services Journal is developed to address key issues currently driving the industry. There is no doubt that the global economic downturn dominated all industries last year and although the financial services industry still faces many challenges in the wake of the crisis, it is time for companies to move out of survival mode and start placing emphasis on promoting long-term stability and growth.

Stress testing scenarios implemented by banks before the crises hit global economies failed in producing results that were able to predict the effect of such a crisis, due to issues with the integration of stress scenarios across risk types. Scenarios were found to often contain simplified assumptions to deal with complex products. This led to results underestimating the losses from these products.

Ina de Vry, Partner in Advisory Financial Risk Services says, “The severity of the international financial crises has caused many banks to question the efficiency and flexibility of their stress testing practices since the results of stress testing performed before the crises underestimated the depth of the crisis in many respects.”

According to the Financial Services Journal, banks that were highly exposed to the effects of the financial crisis but still managed to fare comparatively well, were fortunate enough to have extensive senior management involvement in the development and results of stress testing practices in their institutions. This meant that the results of stress testing informed strategic decision making around liquidity and capital.

The Financial Services Journal emphasises the importance of banks having a flexible infrastructure to support the aggregation of stress testing results. Stress testing provides a complimentary risk perspective to other risk management techniques and the outcome could also provide insights into the validity of the assumptions used in complex risk models used to estimate capital for internal and regulatory purposes.

The challenges facing most banks today is the development of an integrated stress testing framework that serves to fulfil a range of requirements including the effective execution of stress testing at various levels of the organisation that promotes risk identification and control. The involvement of the Board of directors and senior management is critical to ensure the effective use of stress testing results in bank risk management and capital planning.

De Vry emphasises that an integrated and flexible framework is essential and requires adequate documentation of stress tests, especially the assumptions and fundamental elements of the stress tests. “In most cases the underestimation in the stress testing results can be ascribed to inappropriate assumptions that has not been sufficiently debated and challenged.”