LO 56.2: Explain challenges in designing stress test scenarios, including the

LO 56.2: Explain challenges in designing stress test scenarios, including the problem of coherence in modeling risk factors.
One of the challenges of designing useful stress tests is coherence. The sensitivities and scenarios must be extreme but must also be reasonable or possible (i.e., coherent). Problems are inherently multi-factored, making it more difficult to design a coherent stress test. For example, an increase in volatility can lead to credit markets freezing. High unemployment and falling equity prices often go hand-in-hand. It is not sufficient to specify one potential problem (i.e., risk factor) because the others do not remain fixed. The supervisors key challenge is to specify the joint outcomes of all relevant risk factors.
Additionally, not everything goes bad at once. For example, if some currencies are depreciating, others must be appreciating. If there is a flight to quality, there must also be safe haven assets in the stress model. So while it is important to look at, for example, what happens if U.S. Treasury debt becomes riskier and is no longer a safe haven, the model would at the same time have to identify the risk-free asset(s) in which capital would flee under those circumstances.
The problem is even greater when designing stress scenarios for marked-to-market portfolios of traded securities and derivatives. Risk is generally managed with a value at risk (VaR) system. Hundreds of thousands of positions in the trading book must be mapped to thousands of risk factors, tracked on a daily basis. The data that results is used to estimate volatility and correlation parameters. It is very difficult to find coherent outcomes in such a complex, multi-dimensional universe.
The 2009 SCAP tested rather simple scenarios with three variables: growth in GDP, unemployment, and the house price index (HPI). Historical experience was used for the market risk scenario (i.e., the financial crisisa period of flight to safety, the failure of Lehman, and higher risk premia). While the market risk scenario did not test for something new, the overall framework achieved coherence of financial and other stresses of the time period.
One thing to note is that prior to 2011 all supervisory stress tests imposed the same scenarios on all banks (i.e., a one-size-fits-all approach to stress testing). In recognition of the problem, the 2011 and 2012 Comprehensive Capital Analysis and Review (CCAR) asked banks to submit results from their own stress scenarios in addition to the supervisory stress scenario in an attempt to reveal bank-specific vulnerabilities. This was an important step forward from the 2009 SCAP as it gave supervisors a sense of what banks think are the high risk scenarios. This provides regulators with not only bank-specific (i.e., micro prudential) insight but also improves macro-prudential supervision as it highlights common risks across banks that may have been underemphasized or unnoticed before.
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Topic 56 Cross Reference to GARP Assigned Reading – Schuermann
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