The bigger stress testing picture

At the end of March 2014, regulators will be collecting the
first annual Dodd-Frank stress test results from banks in the $10-50billion
bracket. From Q2 onwards, these banks will have the opportunity to improve upon their stress testing processes by incorporating regulatory feedback and
industry best practices. The next round of Dodd-Frank stress test scenarios are
then expected to be released by 15 November 2014, with public disclosures of
stress test results being a requirement starting in 2015.

The fall out of the stress tests will not only be a simple
failure certification and capital plan rejection issued by the regulator. The
real penalty will be the publicity of the failing and the associated
reputational risks that can weigh down a bank’s business. While this may be a
time of industry speculation as we await the results, there are some
interesting observations of how the results could fuel evolution of risk
management in the US financial market:

Pasta or Lasagne?

Different banks have been tackling stress testing in many
ways according to size, complexity, balance sheet structure, and geographical
footprint. However, the one thing they all have in common is the need to reduce
the complexity of their operational and technology infrastructure. Let’s use
the analogy of pasta and lasagne to illustrate. Currently, banks are making big
bowls of pasta when it comes to their data and solution set-up – there are many
different silos of information all intertwined yet separate. In order to
succeed in stress testing, these banks need to be applying a lasagne-based
model to break down these silos and introduce a more layered structure within the bank to help generate a holistic view of risk exposures across the entire organisation’s balance sheet. As part of this, we expect more and more banks to set up or expand the roles of in-house enterprise risk committees, which work to forge collaboration across the organisation.

Cultural shift

While bankers are aware that this is the right approach and
an important part of re-engineering risk management to embed stress testing
into their organisation, many are still in aspirational mode and recognize that
this will be an evolutionary process that will take more time to achieve. A lot
of work needs to be done to achieve this holistic view: vast amounts of
internal data will need to be collected and standardized, technology solutions
will need to be integrated, and sophisticated analytical models will need to be
developed. All of this needs to be underpinned by a formalized governance
structure to oversee all the processes and models.

Changing attitudes

Many banks are still viewing stress testing as a regulatory
burden but whether they like it or not, it’s not going anywhere fast. It’s
understandable that they are feeling the burn, particularly when it comes to
resource and time commitment. The industry needs to work towards automating
these stress tests so less time has to be spent on generating and validating
the results and more time can be placed on drawing insights from the results,
such as informing capital plans. This will be incremental in helping achieve a
more forward looking view of risk for the organisation, thus helping the bank
make better-informed decisions to drive competitive advantage through
regulatory compliance. We anticipate a mind shift among banks to begin to view
stress testing more opportunistically rather than being a regulatory weight
around their necks.