This checklist explains why measuring and identifying exposure to risk has become essential and why the use of stress-testing—a prime tool of risk management—has increased dramatically.
As global financial markets have become more diversified and complex, many more “new” economies have entered the markets. With the greater number of players and the increased funds available, it has become imperative that all parties with a vested interest in markets and risk exposure —from investment banks to private investors—are properly prepared to assess exposure and able to quantify risk. Stress-testing refers to the various ways that financial and other entities estimate their vulnerability to an exceptional event of plausibility.
The use and practice of stress-testing have increased over the past decade following the occurrence of several notable events in the financial markets: the 1997 Asian crisis, the Enron scandal of 2001, and the collapse of Barings Bank in 1995. As the markets turned bearish in late 2007, it has become standard practice for an institution to acquire the ability to stress-test itself accurately.
Many major institutions stress-test their portfolios on a monthly basis to assess their risk profile and gauge the possible effects of various scenarios on their profit and loss accounts. Stress-testing requires that employees are trained to understand the mathematics and theory behind the process to ensure that the information garnered is both accurate and comprehensive.
Stress-testing can be divided into two distinct categories: simple sensitivity tests (SST), and scenario analysis.
The SST explores changes to a portfolio’s value following a change in one risk factor, for example interest rates. It is a very simple yet effective way of flagging up major deficiencies and weaknesses in a portfolio. The SST is frequently used by smaller banks and institutions as well as private investors. The drawback of this technique is that it is not plausible that just one variable should change—a massive increase in US interest rates, for example, would have a massive effect on exchange rates and equities.
This is why larger and more complex organizations use scenario analysis, which takes into account a wide range of possible variables such as exchange rates, equity prices, and interest rates, and extrapolates possible outcomes and their probabilities. The process is not dissimilar to forecasting the weather—like the weather, a financial forecast is susceptible to change and must be repeated regularly.
Stress-testing is only as accurate as the information fed into it. Thus, practitioners must have a thorough understanding of economic theory and the effects on the institution’s portfolio. It is an exceptionally flexible tool that can be applied to virtually any aspect of an institution’s operations that have substantial exposure to risk —country risk, illiquidity exposure, etc. It is not an end-product as stress-testing treats variables separately; companies are currently trying to develop a testing procedure that is more holistic and accumulative in scope.
A properly conducted stress-test program can help insure against otherwise unnoticed risks and flag problematic investment strategies. If the scenarios and metrics of the system are set clearly, a great deal of benefit can be gained, both for long-term strategy and for day-to-day management. Taking a risk is fine, but it must be accurately gauged, and a properly conducted stress-testing procedure can greatly reduce the potential for error in exposure calculations.
If conducted improperly, stress-testing can create a false sense of security. Any stress-test that scored exposure to risk too low would be exceptionally dangerous to an institution. It can be time-consuming and expensive to train employees to use stress-testing, and it must be applied in continually changing environments.
Ensure that the users of the system and the institution’s managers understand the limitations, intent, and scope of the process.
Ensure that the results are produced in a comprehensible format.
Ensure that the stress-test is company-wide.
Dos and Don’ts
Introduce stress-testing; but
Make the reports comprehensible and comprehensive.
Don’t be deluded into believing that stress-testing is an end in itself. Like all tools, it will only be of benefit if used properly.
Don’t assume that just because a stress-test has been conducted the process is complete.