Stress Testing for Banks and Financial Services Companies
Stress Test
A stress test is a risk assessment technique that evaluates the adequacy of capital and assets of institutions and investment portfolios and consequently their resilience in adverse or favourable situations. This is achieved by simulating financial scenarios that may be possible in future.
Who needs stress testing
Stress testing as envisaged here is applicable for Banks and Financial Services Companies. While banks differ in sizes and applicable regulations, their key common feature is dealing with public through acceptance of deposits. This necessitates monitoring of their functioning and health and also attracts stringent regulations, including stress testing. Financial Services Companies that we cover in our stress tests are essentially non-banking finance entities such as those providing home loans, personal loans, car loans, small working capital loans, equipment finance, credit cards, trade finance, leases, asset finance, and such other entities, that have easier regulations albeit are still closely watched.
Why would a stress test be required
Regulators in various territories require banks and financial services companies to undergo stress tests that focus on capital adequacy. Various scenarios are simulated and the effect on capital is measured, and based on such information the institutions under test are advised to maintain a higher level of equity capital, lower their risky assets, etc. as required. Aside from the regulatory requirements of stress testing, overall evaluation of a bank’s health may be done as a strategic exercise. This overall evaluation would cover all aspects of functioning of a bank or a financial services company and evaluate individual risks. The outcome of such evaluation would cover various risks that face the organisation. Answers are sought to the question that if things turn stressful, what would be the impact on various aspects of the functioning of the organization.
Regulators such as Federal Reserve, Bank of England or ECB have stringent requirements regarding stress testing. Such stress tests require an army of resources and budgets of millions of dollars. While banks and financial services companies comply with such regulations and testing, they also simultaneously consider quick methodologies that give results in less time and less cost.
Our Modified Stress Test
We have developed a methodology that we call Modified Stress Test that focuses on all critical areas in a bank or a financial services company. The result is in the form of recommendations that prioritize your actions based on criticality of risk drivers. Risk drivers are both internal to your organisation as well as include macro-economic factors that are beyond your control. Through close monitoring of such factors, you are alerted to scenarios that can unfold and will be able to take corrective steps in advance.
As part of our stress testing methodology,
we model various aspects of your organization such as
|> loan assets,
|> investments,
|> asset-liability management,
|> NPAs,
|> interest rates,
|> organization structure,
|> liability structure,
|> financial products distribution, and
|> payments.
We then evaluate multiple risks that your organization is faced with
|> credit risk,
|> market risk,
|> operational risk,
|> liquidity risk,
|> foreign exchange risk,
|> interest rate risk,
|> business risk / reputational risk, and
|> moral hazard.
Modified Stress Test is an exercise internal to your organization. The aim of this exercise is to help make your capital more robust, make more accurate plans and budgets, and take decisions as per your risk appetite.