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The synergies between IFRS 9 and stress testing models and processes - Q&A

Ahead of the Stress Testing Summit 2017, Antoine Bezat, Head of Stress Testing Methodologies and Models at BNP Paribas discusses with us the importance of assessing the synergies between IFRS 9 and stress testing.

Antoine, can you tell the audiences about yourself and your experience in the industry?

I have a 15 years’ experience in quantitative finance first in market then in credit and now in a transversal role for stress testing. I started at Dexia where I contributed to the implementation of the internal model for market risk and was appointed head of model validation for valuation / pricing and market risk models.

I joined BNP Paribas in 2009 initially in a model validation role, leading the review of the economic capital, stress testing and credit provisioning frameworks. In 2013, I have joined the Group credit risk stress testing team and have been leading the team since 2015.

The organization around stress testing and capital planning has evolved this year in order to leverage stress test as a key capital planning and risk management tool for the bank. A transversal team has been set up that gathers Risk, Finance and ALM resources. I am in charge of the model component of this newly created (hence covering stress testing models for credit, market, ALM, operational risks …).

Can you explain some of the synergies between IFRS 9 and stress testing people and systems?

Under the push of Basel II, Banks have strongly invested in measures of credit risk, EADs, PDs and LGDs, that are “through-the-cycle” or downturn. Typically these measures do not reflect an expectation for the realization of a loss rate or a default rate in the near future, but rather a long-term-average perspective. Under IFRS9, the parameters used have to be point-in-time and forward looking. Hence, they should reflect current and anticipated trends and thus provide the best expectation of the actual realization of a variable in the foreseeable future using all information available, especially macroeconomic forecasts.

The synergy with stress testing is strong as the aim of credit stress testing is to anticipate the value of risk parameters under severe macroeconomic scenarios, as well as under baseline scenarios. Hence stress testing is the area where the banks had already developed capabilities to compute and project point-in-time and forward looking indicators. Moreover, macroeconomic scenario generation processes had already been implemented for this process.

It was thus a natural choice for most banks to leverage on their stress testing infrastructure (providing some potential major evolutions) to comply with IFRS9 requirements in terms of computation of risk parameters.

Can you outline the main challenges of the synergies between IFRS 9 and stress testing models?

Using stress testing models in the accounting context is a clear opportunity to reinforce stress testing and promote the related models and techniques across the institution. From now on, stress testing models will drive P&L impacts and thus be scrutinized, hence better understood by many stakeholders across the organization. It will also be a great opportunity for receiving more feedbacks on model performance and involve more people in order to achieve construction of the most relevant approaches.

But indeed, IFRS 9 comes along with major challenges:

  • • With IFRS9, the paradigm of stress testing teams shifts from risk anticipation and financial planning to accounting and direct P&L impact. It leads to significant changes in terms of governance, reporting needs and in the way to monitor model risk. For example, model recalibration will result in P&L impact, which needs to be managed and explained.
  • • The other important challenge lies in stress testing itself. While stress testing teams are contributing to the implementation of IFRS9, they are also required to develop an approach to stress cost of risk under IFRS9. It is a major challenge both in terms of methodology (because the IFRS9 measure is complex in itself) and in terms of systems (the computation of IFRS9 provisions requires a lot of data that is not always present in existing stress testing systems).

What are some of the operational challenges of similar teams working on both stress testing and IFRS 9?

The evolution of regulatory stress testing requirements over the past few years has forced institutions to develop increasingly complex methodologies with a high level of granularity. There has been less focus on the efficiency of the associated operational processes (design and automation) as these evolutions were mostly short noticed.
With IFRS 9 coming, the same teams now working on both stress testing and IFRS 9 may face the following challenges:

Most institutions retain a relatively small number of staff dedicated to stress testing, while a broad range of other teams are indirectly involved. With IFRS 9, the teams in charge have no room left for time consuming and resource intensive processes. The latter may become unsustainable especially if demands from senior management and regulators continue to increase. To this end, it will be crucial to document the full to-end stress testing process and accurately measure the full costs of delivery in order to identify optimization opportunities and support investment decisions to better design, integrate and automate stress testing processes;

  • • In this context, as teams work on both internal and external stress testing on top of IFRS 9, they will definitely need to embed stress testing into existing planning and forecasting activities in order to leverage existing resources tools, and methodologies. In order to do so, aligning internal and external stress testing would significantly lessen the burden on banks thereby releasing resources to focus on IFRS 9 (project work load and production) and internal risk management (e.g. the static balance sheet assumption potentially detracts from the internal value);
  • • Teams now working on both stress testing and IFRS 9 have been focused in delivering external stress testing within tight deadlines and challenging environment. They will now need to take a step back from the day to day and take some time to design and automate a real capacity of analysis to explain P&L impacts under IFRS 9 as demand from stakeholders will be very high especially considering volatility of provisions and CET1.
  • • Even though no comprehensive credit risk stress testing exercise under IFRS 9 has been conducted yet, it will clearly be an operational challenge for the entire banking industry and the one to come will surely set the path.

How do you see the role of stress testing professional evolving over the 6-12 months?

So far, stress testing professionals were employing significant time and resources in meeting regulatory demands, diverting efforts away from internal stress testing and limiting the value that firms derive from this as external stress testing is primarily used in validating capital resilience, with limited influence in business strategy.

The current change in agenda provides the ideal platform to reform stress testing professional role to:

  • • Support for operations: Conciliate stress testing with business planning and internal risk management requirements in order to insert operationally stress testing into business monitoring and decisions. This will require iterating with businesses notably in order to capture their risk drivers, appetite, requirements…;
  • • Project management: Better invest time and effort to improve and streamline existing processes to enable institutions to continue to meet regulatory requirements given the prevailing trend for ever-stricter regulatory supervision;
  • • Client-facing: IFRS 9 impacts and volatility will definitely bring the light into stress testing professionals. They will be required to rationalize and explain the impacts to a broad range of stakeholders both internally and externally, turning their role into a more “client-facing” role. One of the main drivers defining the future of the stress testing professionals in the longer run would greatly depend on the probability that banks and regulators work together to agree the right balance of effort between internal and external stress testing to preserve the value of stress testing as an internal management tool.

Antoine will be giving a presentation on assessing the synergies between IFRS 9 and stress testing models and processes for a more unified approach at the Stress Testing Summit, 26-27 September 2017. He will touch on key topics in that area such as: Forward economic guidance generation, synergies between IFRS 9 and stress testing people & the importance of consistency in both disciplines.

Antoine will be giving a presentation on assessing the synergies between IFRS 9 and stress testing models and processes for a more unified approach at  the Stress Testing Summit, 26-27 September 2017.