Stress Testing
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.
Our approach to stress testing is to produce 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:
- Cyclicality of minimum capital requirements - understanding the impact of an economic downturn on lenders' rating systems and how this feeds through to PD and LGD
- Cyclicality of actual default and loss experience - assessing the likely movement of default and loss for the given economic scenario
Understanding these two obviously inter-related, yet distinct impacts is vital for lenders as they plan capital management through a stress scenario. Stress testing models allow lenders to build an understanding of the magnitude and timing of funds needed to be channelled through to capital reserves as they face deteriorating economic conditions.
In recent work for clients we have been incorporating the impact of management actions into our modelling frameworks. We have also been addressing the specific problems of ratings migration, in stress testing and in the area of 'through the cycle' calibration of PD rating systems.