Macro-Prudential Policy and Financial Stability: Issues and Challenges December 2013 Intercontinental Hotel Amman, Jordan

Stress Testing Banks and Financial Institutions Good practices Stress testing models and scenarios Practical considerations Mr. Keith Pooley METAC Banking Supervision Technical Expert

The importance of stress testing “Stress testing plays an important role in:  providing forward-looking assessments of risk;  overcoming limitations of models and historical data;  supporting internal and external communication;  feeding into capital and liquidity planning procedures;  informing the setting of a banks’ risk tolerance;  and facilitating the development of risk mitigation or contingency plans across a range of stressed conditions.” Stress Testing and Risk Governance “Stress testing should form an integral part of the overall governance and risk management culture of the bank. Stress testing should be actionable, with the results from stress testing analyses impacting decision making at the appropriate management level, including strategic business decisions of the board and senior management. Board and senior management involvement in the stress testing programme is essential for its effective operation.” Stress Testing and Capital Plans “ Supervisors should consider the results of sensitivity analyses and stress tests conducted by the institution and how these results relate to capital plans.” 3 GOOD PRACTICES WHAT DOES BASEL SAY ABOUT STRESS TESTING?

STRESS TESTING GOOD PRACTICES The following slide provides an example of good practice in relation to the Governance Framework The process is Board-led, with the Board:  proposing some of the scenarios to be run  challenging approaches, scenarios and outputs  approving approaches, scenarios and outputs  receiving sufficient training to support these objectives

GOOD PRACTICES - GOVERNANCE Under leading practice, stress testing needs a set of governance arrangements driven primarily by the Board and an integrated operating framework. Board and senior management engagement Clear responsibilities, allocated resources, and written policies and procedures Embedded into risk management processes and supported with an appropriate risk infrastructure GOVERNANCE FRAMEWORK Outputs are actionable and inform strategic decision making Governance of stress testing and use Regular review of programme to assess its effectiveness

GOOD PRACTICES – OPERATING FRAMEWORK The following slide provides an example of good practice in relation to the accompanying Operating Framework The framework encompasses:  macroeconomic stress tests,  scenario / ‘what-if’ analysis and sensitivity analysis - appropriate for the scale and complexity of the asset classes  assumptions are sufficiently challenged and tested Outputs inform:  management actions and gross and net impacts  Pre-emptive responses to manage vulnerabilities  Strategy and capital/liquidity requirements

Firm strategy OPERATING FRAMEWORK Ca pital planning Identifying capital required to support growth Link to ICAAP Stress Testing Quantitative Elements (e.g. GDP, CPI ) Define scenarios Identify consequence Assess impact (quantitative & qualitative) 7 GOOD PRACTICES – OPERATING FRAMEWORK

TYPES OF STRESS TESTS

Exposure Rating class Sensitivity analysis  Defined by shift in sensitivity variable  Relatively easy to define and implement – often used at trading desk and business line level  Shifts in several variables have to be used in order to simulate historical events  Correct use of stressed correlations between risk types is essential

SENSITIVITY AND SCENARIO ANALYSIS APPLIED TO CREDIT RISK AND MARKET RISK Sensitivity analysisScenario analysis Credit risk Market risk (incl ALM) What if all ratings worsen by one grade? What if default rates double in portfolios X,Y,Z? What if all correlations on our credit portfolio model increase by 20%? What is our collateral recovery rates are systematically 25% lower for real estate collateral? What is the EUR/USD rate changes by X%? Parallel shift of yield curve by X basis points? Increased in implied volatility of European stocks of Y% What if there was an emerging market crisis (contagion effects)? GDP down 6-8%? Deflationary vs. inflationary? What if the previous historical boom and bubble in house prices leads to a long-lasting retail mortgage credit crisis? What if exchanges rates or interest rates behave as they did historically during period X? What if interbank liquidity dries up during next economic shock? 10

THE CLASSIFICATION OF GLOBAL STRESS SCENARIOS Global stress scenarios can be classified accordiing to the construction of the scenarios Identification or relevant risk drivers and risk types. The corresponding elementary stress scenarios are then put together to yield a global scenario Starting from a given multi-risk scenario, identified as being relevant to the risk profile, and the corresponding quantification in terms of single risk types BOTTOM-UP TOP-DOWN Moderate scenarios Challenging scenarios Extreme scenarios

12 TOP DOWN APPROACH TO DEFINING STRESS SCENARIO

HIERARCHY OF STRESS TESTS Global scenarios Scenario analysis Sensitivity analysis

14 LINKING MACROECONOMIC EVENTS WITH THE TARGET METRIC

REVERSE STRESS TESTING – TEST TO DESTRUCTION Reverse stress testing Reverse stress testing should be modelled through various stresses and consider factors relating specifically to the firm as well as the external environment. Considerations when devising tests:  Proportionality  Basis of scenarios: hypothetical v historical  Internal v external shocks  Idiosyncratic v market wide stress  Rapid crystallisation versus protracted impact  Solo v Group It should be used as a risk management tool – not a means of directly increasing capital requirements Scenarios that could lead to business failure Mitigating actions or triggers for future action Why do it? ■ Explore business model vulnerabilities ■ Engage senior management ■ Confront possibility of failure ■ Make decisions that better integrate risk management ■ Improve contingency planning ■ Inform stress testing framework 15

16 EMBEDDING THE STRESS TESTING PROCESS

17 STRESS TESTING DESIGN INVOLVES A LOT OF REFLECTIONS Under which scenarios is my business model seriously endangered? What will cause my business model to fail? What happens to my business in the next crisis? Which risk drivers are relevant to my business? In which scenarios would my largest sensitivities lead to major losses? Whom in my organisation should I involve in the design, modelling, parameterisation and evaluation of stress scenarios How do I translate (top-down) scenarios to relevant risk drivers, and what severity do apply? What level of sophistication in describing and modelling of scenarios do I need to apply to capture their essence? Which parameters should be shocked (how)? Over what time horizon? How are second order effects and feedback incorporated? What do I do with the results of stress testing? To what degree may I anticipate help from the outside (investors, central bank, government)? Design and strategy Methodology Implementation and evaluation

18 KEY SUCCESS FACTORS WHEN SETTING-UP A STRESS TESTING FRAMEWORK Adequately involve business and senior management at all levels of stress testing Clearly define the perimeter, i.e. the group on a consolidated level Identify the variables that have the most effect on target variables Clearly identify the target metric, e.g. the P&L, capital, external rating,… Validate stress testing results, question and refine scenarios across time Create a real risk culture across the organization – get stress testing out of the risk function Link stress testing results to action, e.g. outright acceptance, evaluate contingency planning

THE IMPORTANCE OF STRESS TESTING LIQUIDITY 30 July August February March August September September October 2008 National bail-outs: Germany - €470bn, France - €340bn, USA - $250bn bank nationalization, Spain - €100bn October 2008 Tapped national bail-out funds RBOS, HBOS, Lloyds, Commerzbank, Bank of America, JPMorgan Chase, Citigroup, Wells Fargo, Goldman Sachs, Morgan Stanley and more “Many banks despite adequate capital levels experienced difficulties because they not manage their liquidity in a prudent manner……The rapid reversal in market conditions illustrated how quickly liquidity can evaporate and that illiquidity can last for an extended period of time…..” Basel 3

LIQUIDITY RISK STRESS TESTING 10 risk drivers Wholesale funding Retail funding Funding concentration Franchise viability I Intra-group liquidity Marketable assets Off-balance sheet Intra-day liquidity  Short term market disruption  Long term erosion in funding sources due to ongoing market tightening  Name specific concerns - restricting recovery Combined stress test  Name-specific rumours and bad news.  Downgrade and negative outlook.  Retail run?  Wholesale run? Institution specific (idiosyncratic) Market wide (systemic) Non-marketable assets Basel 3 prescribes stress testing should consider the two types of stress tests below and combinations of both Cross currency

First two weeks  Inability to roll over wholesale secured and unsecured funding  Sizeable retail outflow  Reduced intra-day credit provided by firm’s settlement bank  Increase in payments withheld to a clearer  Prefunding for all payments  Closure of FX markets  Intra-group deposits repaid at maturity, intra- group loans treated as evergreen  Multiple downgrade of long-term rating Idiosyncratic Impact Out to 3 months Sustained leakage of funds Sustained outflow Gradual return to normality Systemic Impact  Uncertainty of accuracy of valuation of assets and those of counterparties.  Inability to realise or realise particular classes of assets only at excessive cost.  Risk aversion in funding markets.  Uncertainty as to the ability of a significant number of banks to meet liabilities LIQUIDITY RISK STRESS TESTING

Core Tier 1 as % of RWAs (base) Core Tier 1 as % of RWAs (Stressed) £ mns EXAMPLE OF A CAPITAL STRESS TESTING Economic variableYearBase CaseRegulatory mandatory test Eurozone Sovereign USGDP %-1.8%-2.1% Unemployment %13.4%13.5% House Price Index %-13.1%-14.7% EuroGDP %-1.6%-3.9% Unemployment %13.1%15.2% House price indices2015-2%-18.2%19.1% Illustrative numbers