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Are Your Practices Amplifying the “Stress” of Stress Testing?

Regulators in Europe and the US are mandating that financial institutions (FIs) embed stress testing into their Internal Capital Adequacy Assessment Process (ICAAP). But as shown by our recent survey of global FIs, conducted jointly with Chartis, most treat these stress tests purely as a regulatory compliance exercise. They are, therefore, missing a key opportunity to embed results into broader efforts around business planning, risk management and capital allocation.

Chartis Fig 4 Stress testing (low res)

Source: Chartis Research 2015
As our survey results show, stress testing, business planning and risk management processes are fragmented. Most FIs, for instance, have separate stress test processes for compliance requirements and for determining risk appetite. This clearly creates a scenario where limited resources are tied up conducting similar processes but for two different purposes. Not a good use of time and effort!

Perhaps even more concerning is that only 15% of respondents state that stress testing is a core item on the agenda for their board, with a further 51% stating that it is an agenda item “to some degree.” Even in larger institutions, where boards are aware of the importance, the procedures, business practices and reporting structures are still not in place to make the necessary changes.

Interestingly, our survey found that whilst Tier 1 FIs are still developing their stress test strategies, Tier 2 companies have progressed further in integrating processes into their day-to-day activities and business operations. This may simply be a result of the sheer size of the Tier 1 institutions – essentially the silos and duplication of efforts around stress testing is magnified across business units in the larger Tier 1 companies.

It is also clear from our survey that Tier 3 and 4 FIs lag behind their larger rivals. This can be attributed to a current lack of regulatory focus on these companies. But chances are high that more rigorous scrutiny is coming. Thus, these companies should invest in the same best practices before regulators are at their doorsteps.

Tier 3 companies, however, are more likely to follow best practices around using third-party advisors. Having an independent reviewer challenge and validate stress test methodologies is absolutely vital to properly assess institutional vulnerabilities. Whilst 50% of Tier 3 respondents employ third-party consultants, only 13% of their Tier 1 counterparts do the same.

Clearly, there’s more FIs can and should do to make stress testing efforts become more than check-the-box compliance requirements. Without a doubt, stress test results should be embedded in business planning and risk management processes in order to eliminate duplication of effort and improve business decisions. At FICO, we’re working with financial institutions to help them not only meet a host of regulatory and capital requirements, but also build these requirements into the day-to-day operations in ways that drive the business. As just one example, our clients are using economically calibrated scores to better understand how different economic scenarios will likely impact consumer credit portfolios in the future, adding a forward-looking element to capital and risk management decisions.

Stay tuned to our blog where I’ll continue to discuss key learnings from this survey. For full results, you can download the newly published report: Leading Practices in Capital Adequacy.

Thanks to my colleague Joanne Gaskin for co-authoring this post with me.

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