Stress Testing - An Overview of Global Best Practice and Areas for Future Improvement

Stress testing has become one of the key prudential tools for Central Banks and Regulators following the financial crisis in the US, Europe and UK during 2007-2009. That period highlighted the inadequacy of regulatory reliance on Internal Ratings Based models that ultimately calculated Risk Weighted Asset requirements for setting capital buffers. Such models, which, amongst other things, were used to calculate the Probabilities of Default (PD’s), the Loss Given Default (LGD) and the Exposure at Default (EAD) for Credit Risk and the Value at Risk for Market Risk based on historical experience, were open to mis-calibration and/or deliberate gaming by firms. The crisis forced regulators in the affected countries to establish a new way of trying to assess the riskiness of banks’ portfolios that would measure wider economic risks and interlinkages in the system, and also be forward looking in its approach. The result was a new system of regulatory stress testing that aimed to combine the macro-economic top-down assessment of the economic system, with the micro-economic bottom-up analysis of individual firms. It has since become the key tool in setting capital buffers for individual firms, whilst also being used to highlight model and data weaknesses and identify key risk issues for Supervisors to focus on. In addition, stress testing is now also used to support assessments of threats to financial stability and in testing out the impact of central banking policy changes across the wider markets. As such, it is important to understand how supervisory stress testing evolved from the recent financial crisis, and to take stock of the developments that have occurred over the last few years, during which stress testing has become a key part of the annual setting of capital buffers and supervisory strategies. This paper therefore aims to summarise the key elements of stress testing regulatory regimes that have been set up in the three major global centres that suffered most during the crisis, and to consider what has been learnt in the last few years of running these processes. It will also look at how this information can help those Central Banks and Regulators who are in the process of building up or improving their stress testing processes to develop their frameworks whilst taking into account the experiences of the three key regulators most affected by the crisis.