A Presentation on the Development of Stress Testing. Demonstrating the impact that Risk Management Models had on the Great Recession and what lessons can be learned from it. There is also a demonstration of an Irish example of a successful stress test, that was one of the fundamental focal points in the lead up to the state's exit from an IMF bailout programme

1. Stress Testing
Pre Crisis and Post Crisis Differential

2. David Viniar Goldman Sachs CFO
August 2007
“We are seeing things that were 25-standard deviation moves, several
days in a row”
To provide some context, assuming a normal distribution, a 7.26-sigma
daily loss
would be expected to occur once every 13.7 billion or so years. That is
roughly the
estimated age of the universe. Andrew G Haldane 13 February 2009
John Maynard Keynes’ famous maxim
“Better to be roughly right than
precisely wrong!”

3. Stress Testing a Historical Perspective
• Over Reliance of Regulators and Banks on VAR
models that later proved to be inaccurate,
stemming from models derived from the Stock
Market Crash of October 1987 and the failure
of Long Term Capital Management in
September 1998
• Two Crises that were fundamentally different
from the Great Recession

4. October 1987 Crash
• Emergence of VaR
• In 1989, JP Morgan
Chairman wanted to
know how much could
“it lose if tomorrow
turns out to be a
relatively bad day”?
• VaR gained preeminence with the
banking community,
leading to the design
and implementation of
Basel 2.

5. Was VaR responsible for Meltdown?
• Between October 1998
and June 2007, Bank
Balance Sheets trebled
and their share prices
increased almost 60 %.
• Belief in Risk
Management, the new
frontier in Risk
Management was
alleviating risk?
• As Galbraith noted
innovation is not
adjudged critically,
every new “innovation”
inevitably proves to be
only a mild derivation
from prior products,
thus risk is masked.

6. NINJA Mortgage
• Classic Example of Asset that quickly became a
liability, not much of an issue when prices
were rising as Baker (Center for Economic and
Policy Research, p. 18, ISBN 978-0-615-533490) notes that house prices were had increased
by 30 per cent ahead of inflation from 1996 to
2002, which was considerably ahead of the
long run average rate of increase

7. Diagnosing Market Failures
Haldane states that Market Failures Fall into 3 Categories
1. Disaster Myopia
2. Network Externalities
3. Misaligned Incentives

8. Disaster Myopia
• This is the mispricing of risk by financial
institutions, as stated by Kahneman, Slovic
and Tversky (1982)
• “It is well established in cognitive psychology
that economic agents have a tendency to base
decisions rules around rough heuristics or
rules of thumb”

9. Network Externalities
• The “Contagion Effect”
• Lehman Brothers collapse had a massive
contagion effect on the worldwide financial
system leading to a collapse in World
Interbank Markets.
• The Contagion Effect along with excessive
Leverage could collapse a previously solvent
institution

10. Misaligned Incentives
• Financial Innovation has lengthened the
international chain from ultimate borrower to
end Investor.
• A prime example of this was the setup of ACA
Capital Management as an instrument for
Paulson & Co. to short in the expectance of a
collapse.

11. Hubris or Model Failure?
• “Caveat Emptor” those who took a contrarian
position at a critical juncture reaped great
rewards, as they resisted the overwhelming
“Irrational Exuberance” and invested their funds
accordingly.
• Not necessarily a “Model Failure” as the VaR
assumptions based upon Probability of Default
and Loss Given Default is fundamentally sound,
but in this case was primarily affected by
“Disaster Myopia”

12. Lessons Learned?
Haldane Suggests
1.
2.
3.
4.
5.
Set The Stress Scenario
Regularly Evaluate the Stress Scenario
Assessment of the second-round effects of stress
Translation of Results into firms liquidity and capital
planning
Fifth Transparency to regulators and Financial Markets

13. 1.Setting the Stress Scenario
• Firstly the Regulators should set out an
adverse economic situation sufficiently
extreme to constitute a tail event
• This will enable banks to overcome Disaster
Myopia

14. 2. Regular Evaluation of Common
Stress Scenarios
• Banks are now required to conduct regular
evaluations of their positions relative to a set
of common scenarios provided by regulators.
• We are already seeing this with the EU wide
Stress Tests, Irish Prudential Capital
Assessment Review
• Last Year Citigroup attempted to return Capital
but was instructed to hold the capital in
reserve by US Regulator’s

15. 3.An Assessment of the Second Round
Effects of Stress
• The common stress test as mentioned in
Section 2, should be considered the starting
point, in that their effect should be considered
with respect to asset sales and liquiditiy and
what Contagion Impact this could have on the
banking system as a whole.

16. 4.Translation of Results into Firms
Liquidity and Capital Planning
• The results should be able to influence
Management decision making and overcome
internal incentive problems that need to be
overcome.

17. 5.Transparency to Regulators and
Financial Markets
Stress Tests should clearly set out the stressed
situation, the results and the resulting actions that
need to be taken to overcome potential liquidity or
capital issues, this will improve transparency thus
providing investors with a better snapshot, while
increasing the authority of Risk Managers

18. Evolving Nature of Stress Testing
1. Credible Testing of Stressed Situations
2. US Bank Stress Test’s conducted after the
Financial Crisis were instrumental in
returning the institutions and subsequently
the respective economy around, whereas the
European Bank Stress Tests of 2011 were
largely considered to be a Watershed.

19. Stress Testing
Financial Measures Programme
Single Supervisory Mechanism

20. Financial Measures Programme 2011
• Aims to place the Irish banking system in a position where it can “fund
itself and generate capital without undue further reliance” on the Irish or
European public sectors.
• The FMP comprises 3 separate but complementary exercises:
– An independent loan loss assessment exercise performed by BlackRock
Solutions (BlackRock), the results of which have informed the calculation of
capital requirements under the PCAR.
– The Prudential Capital Assessment Review (PCAR), an annual stress test of the
capital resources of the domestic banks under a given stress scenario,
undertaken in order to calculate the cost of recapitalisation required to meet
Central Bank-imposed requirements.
– The Prudential Liquidity Assessment Review (PLAR), which establishes funding
targets for banks participating in the PCAR in order to reduce the leverage of
the banking system, reduce banks’ reliance on short-term, largely central bank
funding, and ensure convergence to Basel III liquidity standards over time.

21. Blackrock Loan Assessment
• Blackrock loan assessment exercise measured nominal loan
losses banks might experience under base and adverse
scenarios over 3 year (‘10-’13) and loan horizon timeline
stretching out to 2040
• “Base scenario” in line with EU forecasts for Irish Economy
• “Adverse Scenario” (i.e. stress scenario) represented a further
economic contraction

22. Projected Loan Losses

23. PCAR Stress Test
• Top down exercise which required banks to model the impact of certain
assumptions on their balance sheets and profit & loss accounts
• Methodology closely in line with EBA stress test parameters thereby
ensuring ensure capital requirements under PCAR would satisfy EBA
standards
• Base case scenario assumed CET1 ratio of 10.5% and stress case 6%.
• PCAR stress test relied heavily on Blackrock’s assessment of loan losses
and PLAR exercise
• Additional buffers to ensure sufficient capital to cover post 2013 events
and contingencies also included
• Attempt to estimate the effects of a severe but plausible macroeconomic
scenario and to size the level of capital injection that would enable banks
to stay above the minimum level of solvency even under the assumed
severe scenario.

24. PLAR
• Top-down exercise which required banks to meet a range of
target funding ratios
• Central target is Loan to Deposit ratio which effectively meant
the shrinking the balance sheets of relevant banks (i.e.
Deleveraging)
• €72.6bn net loan deleveraging target for AIB, BOI, EBS & ILP in
the period 2010-2013
• Range of assumptions in relation to funding used such as 0%
max annual growth in deposits, how much growth could be
achieved in wholesale funding markets and cost of funds
projections.

25. PCAR Methodology

26. FMP 2011 Outcome

27. PCAR 2011 Review as at 30/6/2012
• In summary, included banks were “in aggregate and with all
other things being equal” inside the stress case but outside
the base case.
• Banks had recognised greater than expected base case loan
losses and 63% of stress case loan losses.
• Performed better than expected in terms of projected
deleveraging losses

29. Challenges Highlighted by 2012 Review
• Macroeconomic variables used in projecting base and stress scenarios
generally came in somewhere between the two scenarios, however a
number of variables (e.g. house prices, unemployment) were close to
stress case.
• Pre provision and deleveraging operating profits of banks under PCAR
projections for 2012 on annualised basis for 6 months to June 2012.
• New Central Bank guidelines issued post 2011 PCAR resulted in earlier
recognition of losses/impairment charges relative to those assumed in
2011 PCAR.
• Ultimate judgement will have to come at end 2013.

30. Single Supervisory Mechanism
• Regulation came into force in November 2013
• ECB, in conjunction with National Authorities, will carry out a
“comprehensive assessment” over a 12 month period prior to SSM coming
into effect in November 2014
• Selection Criteria:
• 3 largest banks in the country by assets
• Asset size >€30 bn
• Assets comprise more than 20% of country’s GDP.
• Expected to cover c.130 financial institutions covering approx. 85% of euro
area bank assets.
• Capital benchmark set at 8% of CET1 (i.e CET1 4.5%, 2.5% capital
conservation buffer and 1% add-on)

31. Methodology

32. Commentary
• “The exercise will be risk-based and selective, but at the same
time we want to make sure that there are no nasty surprises
in other parts of the balance sheet” Ignazio Angeloni, Director
General Financial Stability ECB 23/10/13
• “Banks do need to fail to show its (the asssesments)
credibility” Mario Draghi, President ECB, Bloomberg Television
23/10/2013

33. Conclusions
• Stress-Testing not a means in itself. Needs to
be part of decision making process.
• Possible variables almost infinite.
• Stress Testing is here to stay ad infinitum!

34. References
•
•
•
•
Central Bank of Ireland, The Financial Measures Programme Report, March 2011
Central Bank of Ireland, PCAR 2011 Review, 2012
European Central Bank, Note on Comprehensive Assessment, October 2013
Financial Times 23/10/13