Are stress tests fit for purpose? - Editor's Blog -

The next crisis will have different causes from the last one. Banks need to look beyond stress tests in their risk management, writes Brian Caplen.

A stress test used to be something a bank performed on itself. Following the financial crisis, regulators started obliging the major banks to jump through the hoops of external stress testing. Those that failed hit the headlines for all the wrong reasons.   

But 10 years after the crisis, are stress tests focusing on the most critical risks? Risks have changed and maybe the new ones are less amenable to stress testing.

A typical stress test will ascertain whether banks have enough capital to cover losses if the property market falls by 20% or if unemployment goes above 10%. All well and good but banks now hold vastly more capital and the loan-to-value ratios of their mortgage portfolios, for example, are much more conservative than in pre-crisis days. Unsurprisingly,  the majority of banks now pass the stress tests imposed on them, which in itself suggests that maybe it is the stress test that now needs updating.

What about the new risks out there – a cyber hack, an IT meltdown, reputational risks related to the new emphasis on environmental, social and governance strategies, or the risks of being accidentally used for money laundering?

These risks are not easily captured by a stress test, even a redesigned one. But the good news is that data analytics is now at a stage whereby banks can start to model some of these risks using the latest machine learning techniques to make sense of unstructured data and behaviour patterns. They also have applications to improve the fundamental credit decision-making process. 

Far-sighted banks will treat stress tests as a hurdle they need to clear to lay the groundwork for doing a massive overhaul of their risk management operations and make them fit for the current very complex risk environment. 

Brian Caplen is the editor of The Banker. Follow him on Twitter @BrianCaplen

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