Stress Testing ____________________________________________________
To date our work has been in the credit risk area of stress testing, which has become increasingly important to firms. Understanding the firm’s credit risk position in the face of recession scenarios has become essential to financial institutions to demonstrate the strength of the institution and instill confidence in their brand.
The key to our approach to stress testing is being transparent in our methods and assumptions in order to produce bespoke evidence based analysis focussed on predicting the impact on capital requirements throughout firms 'downturn' economic scenarios. We do this by addressing the two ways by which funds may need to flow in to regulatory capital as economic circumstances worsen. These are:
- The impact of an economic downturn on rating systems and its affects on PD and LGD
- Assessing the likely movement of default and loss for the given economic scenario
Stress testing is an integral part of the Basel II approach, both under Pillar I and Pillar II and an essential component of any ICAAP (Individual Capital Adequacy Assessment Plan). The FSA have made it clear that lenders need an understanding of how capital requirements and losses evolve through a recession. This is both as a test of adequacy of capital reserves and to allow capital management planning to take into account potential volatility in regulatory capital through the economic cycle.
Increasingly our output is being used not just to support applications for IRB status under the new Basel Capital Adequacy rules, but also to input into strategic planning via providing tools for scenario analysis.
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