An important modelling decision faced by risk management is the selection of plausible scenarios to support forward looking risk analysis and stress testing. For example, the computation of Expected Credit Losses (ECL) under IFRS 9 requires an accommodation of suitably devised long-range scenarios.
A common component to applications of Scenario Analysis in Financial Stress Testing is the set-up and use of a framework. The framework provides the linkage between macroeconomic scenarios and risk metrics for the purpose of projecting financial metrics under the mulltiple economic scenarios.
Vector Autorregression (VAR) is a useful method for analysing macroeconomic and financial data. Specifically, the VAR method permits analysing and accounting for the dependence and dynamics of the macro variables used for scenario building.
Scenario Narrative
Stress Testing is well established as a risk management tool across financial institutions. This holds particularly true in in relation to Bank Capital, where regulatory requirements demand that banks adhere to regular internal and external stress testing exercises. A common question of interest to Portfolio and Risk Managers when evaluating the uncertainty of extreme market events is the following:
“How sensitive is my portfolio to losses as a result of macro and financial shocks?”
Macro Stress Testing aids in exploring how hypothetical future shocks deemed to affect the economic and financial environment transmit to the portfolio losses and the income conditions of financial organisations. A major objective of any stress testing exercise is to examine the solvency of and profitability of financial institutions in the advent of crisis. To facilitate this objective the design of the scenarios used in stress testing is therefore required to adapt to the specific risk and portfolio perspective of each organisation. This requirement is facilitated for example by incorporating suitable liquidity and funding shocks into the design of scenarios.
Scenario Design
The scenarios used for macro stress testing should be devised with view on risks that matter. Each financial institutions has a specific risk profile dependent on the prevailing economic and financial conditions over the periods considered. Notheworthy tha stress testinng scenarios are not meant to forecasts of economic conditions in the future!
Starting point for scenario design is the identification of macro and financial risks that could impact negatively on the financial or solvency position of the financial institution. Following the identification of key macro risks and variables with specification of shocks applied to these variables the portfolio impact can be analysed.
Market Risk Stress Testing
Despite the common standards in using Value at Risk (VaR) and Expected Shortfall (ES) metrics, significant residual risks remain due to extreme and random market moves in the risk drivers. Ideally, forward looking scenarios should be evaluated in Market Risk Stress Testing to identify plausible and extreme shocks. However, scenarios based on historical data are often preferred due to the traceability of evidence for identifying shocks.
After the design of suitable scenarios for the core assets a scenario expansion needs to be applied to capture the responses of the non-core assets to the shocks in the drivers. The modelling of the co-dependence between variables under stressed market conditions is essential too. Typically the scenarios provided in regulatory or internal stress tests specify the time path of some key variables only. To exemplify the case for scenario expansion, consider a scenario where GDP growth and inflation change of EU countries is available, but US macro and financial variables are left unspecified.