Stress testing is an important tool to evaluate the potential vulnerability of a financial institution to economic and financial shocks, and to assist in determining appropriate risk management arrangements.
In recognition of this, APRA requires stress testing in various prudential standards. Beyond APRA requirements, stress testing is a powerful tool for the board and management of ADIs to establish their risk appetite and evaluate the adequacy of their risk management framework.
It can be used to determine an ADI’s tolerance for exposure to particular categories of credit risk, exposure concentration risk, market risks and liquidity risk. For example, stress testing can be used to assess the maximum level of exposure an ADI might prudently have to residential lending, commercial lending, lending to particular industries and lending to particular regions. It can be used to inform the calibration of lending criteria within particular categories of lending. Stress testing is equally powerful in assessing liquidity buffers, the use of different funding options and the design of lending and funding products, drawing on potential types of liquidity shocks.
Stress testing is therefore an important tool in reviewing and refining risk appetite and risk management. It is equally important in the ICAAP process by providing information on the level and composition of capital required.
Stress testing can be done using various techniques, but typically fall into three categories:
- Scenario-based stress testing – where an ADI’s balance sheet strength is assessed by reference to economic and financial shocks consistent with a particular scenario.
- Sensitivity analysis – where an ADI’s exposure to particular types of risks are assessed by applying shocks to just that risk category.
- Reverse stress testing – where an ADI’s resilience is assessed by determining the magnitude and duration of shock required to cause the ADI to fail or breach a regulatory requirement.
Stress tests should be seen as an important tool in the risk management process of any business.
In 2011, APRA asked the six largest ADIs to prepare recovery plans in a pilot program on recovery planning – ie planning for how to restore an ADI to financial soundness following a significant capital or liquidity shock. Now that the pilot program is complete, APRA has stated that it expects the larger ADIs to continue to develop their recovery plans in the context of their normal stress testing and ICAAP processes. It has also extended recovery planning requirements to mid-sized ADIs, including regional banks and a number of mutuals.
Regardless of APRA requirements, recovery planning is an important element of any financial institution’s risk management and governance frameworks. Recovery plans are an important means by which financial institutions – large and small – can assist themselves to survive distress events and thereby maintain franchise value for shareholders or members.
There is a direct parallel in this regard between recovery planning for financial distress events and business continuity planning for operational disruptions; both seek to ensure that the ADI can survive threats to its business and both are essential for protecting shareholder/member value.
As with any plan, recovery plans need to be reviewed regularly and kept up-to-date and periodically tested to assess their effectiveness.
Financial crisis testing is similar to business continuity testing, but focuses on financial distress situations rather than the sorts of events that are addressed in business continuity plans. Financial crisis testing is applied to the kinds of things recovery plans are designed to address, such as testing for how an ADI would seek to recover from a substantial loss of capital or a liquidity shock.
This type of crisis exercise seeks to assess the ability of the financial institution’s board, management and staff to respond to the crisis. They are particularly useful in testing an ADI’s recovery plan and in assisting to strengthen risk management and governance frameworks.
To get maximum value from a financial crisis exercise, they generally need to involve the key directors and senior management of an ADI, given that any crisis of significance will likely involve very senior people in the organisation.
Stress testing, recovery planning and crisis testing can be applied individually as distinct processes, but can also be viewed as parts of an integrated package of tools available to strengthen an ADI’s governance and risk management.
Each tool reinforces the other. For example, stress testing helps to inform the design of recovery planning and crisis testing by identifying the kinds of financial stress events that could threaten the financial soundness of an ADI. The recovery planning process helps to better inform directors and management about the potential consequences of key stress events and how to plan for them. Financial crisis testing helps to evaluate the effectiveness of recovery plans and provides valuable insights to assist in revising and improving recovery plans.
The success of these tools in the overall governance and risk management processes much depends on the quality of preparation in planning and executing the processes involved, and the quality of follow-through, including the reporting back to the board and identification of action points to address issues raised.
KPMG has the experience, skills and knowledge, and the management processes, to assist ADIs to get the best value from stress testing, recovery planning and crisis testing – both as individual tools and as part of an integrated package.