LATEST THINKNG

The future of stress testing

An integrated framework aligned to risk appetite

A NEW ALIGNMENT

Stress testing processes and results can help financial institutions refine risk strategies.

Comprehensive Capital Analysis and Review (CCAR) frameworks have, in less than a decade, become an essential tool for financial institutions. And now this evolution is coming full circle, as firms work to integrate CCAR analyses into enterprise risk appetite, capital and performance management strategies. Initially, stress testing performance metrics were not aligned with corporate strategy in these areas—but that is changing, as firms strive to capture efficiency gains and boost return on investment.

Aligned decision-making processes, a common set of key performance indicators (KPIs) and integrated monitoring, analytics and reporting are all essential in helping the Chief Executive Officer, Chief Financial Officer and Chief Risk Officer shape an institution’s risk profile and financial performance to meet regulators’ expectations. Stress testing processes and results can help cultivate and refine these resources, and also support enterprise-wide management of balance sheet and capital actions.

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THE INTEGRATED STATE

When an integrated approach is working, a financial institution’s capital needs are linked to its strategic plan and to its risk appetite targets.

In an integrated state, there is no need for institutions to view their risk and capital management programs as separate efforts. Instead, they can explore ways to strategically integrate these programs. While the processes for CCAR and economic capital management follow different paths, they can be bridged.

The framework requirements for CCAR focus on providing and consolidating end-to-end data, methodology and forecasting components from all lines of business (LOBs) and relevant functions across the enterprise. Capital forecasts for portfolios, LOBs and for the enterprise are based on the institution’s business and risk strategy, tested under stressed conditions.

Economic capital processes, by contrast, exclude such stressed forecasts, with planning typically housed within a centralized operating model. Results do not provide insights into the consequences of specific stress scenarios or events.

CCAR stress tests and scenario analysis at the LOB and enterprise level can complement economic capital results—for a more holistic view of capital and risk appetite impact.

CCAR STRESS TESTS AND SCENARIO ANALYSIS CAN COMPLEMENT ECONOMIC CAPITAL RESULTS.

FOUR PILLARS

Components of an integrated framework include continuous alignment and rebalancing of balance sheet, risk and capital decisions in these four areas:

STRATEGIC PLANNING / RISK APPETITE (RA)

Growth strategies and corporate RA that impact the availability and deployment of capital
Business plans linked to capital strategies including capital allocation, risk-adjusted performance and incentives
Dynamic monitoring and recalibration of RA targets and thresholds

RISK MANAGEMENT

Identification and assessment of all material risks
Risk management policies and procedures linked to capital adequacy levels
Stress scenarios that impact liquidity, capital access and funding requirements

BALANCE SHEET MANAGEMENT

Dynamic management of balance sheet composition for risk-weighted assets improvement and resilience to external shocks
Determining “strategic buyer” capital levels accounting for cyclicality
Enhanced asset-liability management (ALM) capabilities linked to stress scenarios

CAPITAL MANAGEMENT

Improvement in the sources vs. uses of funds and capital targets formulation
Refinement of capital distribution plans (dividends, repurchases)
Capital contingency plans, KRIs and triggers

CONVERGENCE

The intense focus on CCAR framework requirements in the post-crisis era has overshadowed the importance of sound economic capital management practices and past achievements.

Now it’s time for these areas to converge. To accomplish this, the offices of the CEO, the CFO and the CRO should collaborate in instituting an integrated framework, accounting for the strengths and limitations of previously separate and stand-alone capital planning approaches. When they are combined, CCAR and economic capital can realize significant improvements in risk and capital management.

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