Federal Banking Agencies Stress Testing Guidance – Algorithmics’ response says transition from silos to enterprise view of risk will be challenging

London, New York and Toronto - 17 October 2011

In its recent response to the Federal Banking Regulatory Agencies[1] guidance document, ‘Proposed Guidance on Stress Testing for Banking Organizations with More Than $10 Billion in Total Consolidated Assets’, Algorithmics comments that the greatest challenge for banks will be in rising up out of the risk silos to perform enterprise-wide stress testing. Algorithmics notes that if banks can aggregate their product and counterparty risk they can not only comply, but can also avoid the dangers that come from risk segregation - such as duplication and mismanagement if potential risk diversification and concentration effects are not taken into account.

Dr Mario Onorato, Senior Director of Balance Sheet & Capital Management Solutions at Algorithmics and Honorary Senior Lecturer, Cass Business School in London, said: “It is clear that banks need to move away from their, in the main, siloed approach to risk management. To achieve this, senior management and the board must actively participate in implementing an institution’s enterprise-wide integrated stress testing framework, including scenario selection, and also ensuring that there is a robust stress testing infrastructure with appropriate IT systems and resources in place. In my opinion, the most important elements of the guidance are the requirement for banks to implement enterprise-wide and reverse stress testing frameworks, since both of these approaches will allow banks to rise above the silos to perform fully integrated stress testing.”

Algorithmics’ response focused on:

• Reverse Stress Testing
Few institutions have the technological ability to undertake reverse stress tests and will require significant effort to build and incorporate this into their overall stress testing framework. Banks will need additional clarity on how the Agencies intend to use the results, and the need for consistency with other international regulators.

• Regulatory arbitrage will become a danger. To avoid it, Algorithmics recommends the Agencies should create minimum common scenarios which all organizations will need to incorporate on top of their current stress testing programs.

• Need for stress testing benchmarks
Because stress testing frameworks differ widely between institutions with different activities and contexts, and because local credit conditions vary, Algorithmics recommends that some standard stress coefficients or models should be suggested by the Agencies as a benchmark.

Dr Onorato concluded: “Banking is an international business and it is essential that there is consistency in regulation worldwide if regulatory arbitrage is to be prevented. The Agencies’ proposal differs from Basel and FAS by not acknowledging the need for common supervisory scenarios for banks to report under. It is important for banking organizations to realize that not all banking failures are driven by lack of capital. Operational risks or changes in the market perception of an institution can also cause institutional failure and these factors must also be included in the enterprise stress testing framework.”

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