During FINCAD’s Best Practices in Stress Testing webinar on March 12, 2014, Medy Agami of CELENT’s Finance and Risk Practice discussed challenges, best practices, and innovation in stress testing.
One-size-fits-all fits no one
According to Medy Agami, the biggest challenge facing the industry is regulators’ one-size-fits-all approach to stress testing. Overcoming this approach requires market participants to understand the similarities and differences among buy-side and sell-side firms and communicating these fragments to regulators to piece together the entire stress-testing puzzle. Firms must all get to the same destination but, while common principles apply, tactics will vary.
Optimal stress testing leads to competitive advantage
Ongoing infrastructural changes to stress testing requirements and regulator unpredictability are encouraging firms to adopt a transparent, agile, and integrated enterprise-wide approach. With the right platform and cultural mindset, some are positing that optimal stress testing exercises yield second-order competitive advantage in the new sustained reality of capital constraint.
Transparent and communicable stress testing results
Challenges remain for most firms in transparently listing modelling assumptions in an integrated framework and communicating stress testing output effectively. Ad-hoc stress testing infrastructure is causing significant hurdles:
- Trouble in model reconciliation across the enterprise
- Necessity to have highly skilled human resources who understand the piecemeal collection of Excel workbooks
- Reliance on a small number of people to know the various modelling assumptions and subsequently communicating them effectively.
The up-front cost of an integrated enterprise-wide approach deters many firms from adopting this approach but, over the long run and in the context of increased and evolving stress-test requirements, the ad-hoc approach leaves much to be desired.
Aggregate and granular view of scenarios and sensitivities
Compliance requires an enterprise-wide view of risk with both aggregate and granular detail. Producing risk at both levels has both theoretical and practical limitations. At the theoretical level, Medy Agami notes that stress testing only looks at short term accounting losses of a stressed scenario and fails to capture risk that materializes over a longer horizon. Consequently, the results are not appropriate for applications concerning long term value creation. On a practical level, the widespread inability to produce results at a granular level across products, regions, customer segments, and trades creates limitations in understanding capital adequacy and solvency risk drivers.