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Stress Testing – what does it really mean? Gill Ringland, CEO & Fellow, SAMI Consulting

Stress Testing – what does it really mean? Gill Ringland, CEO & Fellow, SAMI Consulting. www.samiconsulting.co.uk Future proofing – robust decisions in uncertain times. SAMI Consulting 2006. SAMI in Financial Services. Abbey National Bank of Scotland Euler Halifax Legal & General

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Stress Testing – what does it really mean? Gill Ringland, CEO & Fellow, SAMI Consulting

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  1. Stress Testing – what does it really mean?Gill Ringland, CEO & Fellow, SAMI Consulting www.samiconsulting.co.uk Future proofing – robust decisions in uncertain times SAMI Consulting 2006

  2. SAMI in Financial Services • Abbey National • Bank of Scotland • Euler • Halifax • Legal & General • MAN Group • Nationwide • Scottish Equitable • Swiss Re UK Life and Health SAMI Consulting 2006

  3. Agenda • Introduction • Stress testing and sensitivity analysis • Basel 2 Pillar II • Role of scenarios • The Risk Map • Using stress testing • Trends in stress testing • Conclusions SAMI Consulting 2006

  4. Stress Testing SAMI Consulting 2006

  5. Stress testing and sensitivity analysis Sensitivity analysis is used to ascertain how a given model output depends upon the input parameters. Stress testing is used to determine the stability of a given system or entity. It involves testing beyond normal operational capacity, often to a breaking point, in order to observe the results. SAMI Consulting 2006

  6. Basel II • Sets capital asset requirements for FS organisations • Pillar I – minimum Capital Requirements, related to historic credit, market and operational risk • Pillar II – the risks not covered by Pillar I and the action that should be taken • Pillar III – Market Discipline – requiring forms to publish details of risk management • Risks not covered by Pillar I • External risk & business cycles • Pillar II • Any risk which could affect capital requirements • Supervisory processes for monitoring risk • Stress testing to test model of the business SAMI Consulting 2006

  7. Pillar II • Principle 1 of Pillar II • “Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels” • Comprehensive assessment of risks: • Credit, Operational, Market, Interest rate, Liquidity risk, • Other (e.g. reputation and strategic) risk • A method for robust assessment of risk profile • Stress testing using Scenarios SAMI Consulting 2006

  8. Scenarios • Scenarios are • “an internally consistent view of what the future might be”, • “not a forecast but one possible future outcome” • Professor Michael Porter, Harvard Business School Forecasts Scenarios SAMI Consulting 2006

  9. Role of Scenarios • Takes a view across the business outside current responsibilities • Dialogue and modelling at senior levels about assumptions • Creates a shared understanding, less defensiveness in management team • Mechanism for integrating types of risk • Early indicators improve organisational readiness • “Memories of the future”, first explored by Ingvar in 1985. • Thinking out of the box, • Ability to see new risks and opportunities beyond the current business cycle • Framework for anticipating and scoping unexpected loses SAMI Consulting 2006

  10. The Risk Map Reputation Risk Organisational Risk Political fragmentation Climate change Pandemics Demographics Nuclear proliferation Religious Fundamentalism Operational Country/Region Organisational Risk Financial/markets/credit Legal & intangibles External Risk Political/regulatory Strategic Risk SAMI Consulting 2006

  11. Agenda • Introduction • Using stress testing • Expected and unexpected losses • Using scenarios for stress testing credit risk • Stress testing for strategic risk • Trends in stress testing • Conclusions SAMI Consulting 2006

  12. Expected losses (EL) • Sensitivity analysis • Calculated by Internal Ratings-based (IRB) algorithms • F-IRB, A-IRB • Capital & assets weighted for risk • Definitions of capital – Tier 1 etc • Well-capitalised etc • Leads to risk-based pricing of financial products • Many software packages to calculate • Based on credit risk models • Has reduced some organisation’s capital requirements and increased others’.

  13. Unexpected losses (UL) • Stress testing: model breaks due to e.g. • Disruptive events e.g. 9/11, pandemics • Cultural or demographic changes move credit risk parameters beyond envelope • Reputation risk events e.g. money laundering discovered • Operational risk costing say more the 20% of annual profit – hacking – loss of building – fraud – Y2K • Cost of liabilities – pollution, asbestos • Handle through modelling of scenarios which are qualitatively different & explore beyond the sensitivity analysis envelope • Then re-calculate capital requirements with new assumptions

  14. Scenarios to stress test credit risk • Conventional analysis based on • Geographic region’s historic features • Customer market segment or industry historic features • Customer revenues based on history • External credit risk scores for customer type based on history • What could cause history not to be a good guide to the future? • External factors e.g. Asia crisis in 1997, • attitudes to debt e.g. students in the UK 2005, ---- • Use scenarios to set context for analysis in different possible futures

  15. News & Media releases printable version SAMI Consulting 2006

  16. Scenarios to test strategic risk • Insurance company exploring risk to expansion in India • Used scenarios developed for the city of London • the impact of China and India on Financial Services in the City of London • China in 2015 • India in 2015 • Report published in October • Workshop for Board of insurance company SAMI Consulting 2006

  17. The Elephant Lumbers along Federal, subsidiary style of governance Centralised system of governance The Elephant Breaks its Chains Retreat to the Woods Now Liberalisation is reversed Liberalisation accelerates SAMI Consulting 2006

  18. Example of Stress Testing • SAMIHalfDay™ to help the Board of an insurance company to test their strategy for India • Need for research to tailor the scenarios to the scope of the organisation and/or topics concerning the Board • Session 1: forces in the developed and developing world – presentation – • based on The Challenge Forum! database • Session 2: India – threat or opportunity – presentation – • based on research and interviews • Some of the risks and opportunities • Session 3: brainstorm of risks under each scenario • Model risk for the business • Write up by SAMI & feedback session 3 months later. SAMI Consulting 2006

  19. Agenda • Introduction • Using stress testing • Trends in stress testing • Timescales • Focus – risks, applications • Kinds of stress testing • New concerns • Portfolio analysis • Conclusions SAMI Consulting 2006

  20. When do you expect to be compliant with Pillar II?

  21. Which Stage of the Pillar II Project are you? Figure 2 - At

  22. Which Risks are you Focusing on?

  23. Which Business Applications are you Focusing on? Figure 5 -

  24. What Kind of Stress Testing will your Pillar II Tool Provide

  25. Trends – new concerns • Cross border organisations – • host country or parent country standards? • Money laundering • Corporate governance • Choice of vendor products v.s. in-house software • Impact of electronic banking • Disruptive events • Changes in customer behaviour • e.g. changes in attitudes to debt • Working at business unit level c.f. group level • Concerns that need portfolio level analysis SAMI Consulting 2006

  26. Portfolio analysis using scenarios • ED & F Man was formed in 1700s to grow sugar in the West Indies: • By 1999 ED & F Man consisted of four Divisions • Sugar growing/refining/shipping etc • Insurance • Stockbroking • Derivatives trading • The question we were asked was • could using scenarios reduce their losses on sugar futures? • We suggested a better view of their portfolio would provide a context for them to answer • Workshop • based on scenarios for the City of London in 2020 St Andrews Management Institute (SAMI)

  27. Rapid advance in use of technology Fragtech Globetech Global integration stability Fragmentation volatility The Fourth World Slowglobe Technology advances slow City of London in 2020 St Andrews Management Institute (SAMI)

  28. What happened next • Workshop • Each of 4 Divisions asked separately to stress test their business under each of the scenarios • Divisional teams concluded that each Division fitted in a different scenario • This led to an understanding of the sources of blockers to communication and decision • Also why the organisation was not getting synergies across the portfolio • Sold off sugar business, then evolved insurance, stock-broking to align with derivatives • MAN Group moved from FTSE 350 to FTSE 100 as focused derivatives trader St Andrews Management Institute (SAMI)

  29. Agenda • Introduction • Using stress testing • Trends in stress testing • Conclusions SAMI Consulting 2006

  30. Conclusions: Why stress test? • Sensitivity analysis • To test the behaviour within the current model • Stress test • To get a view of risks and opportunities outside the current business cycle • Breaking the current model • Credit risk • Global scenarios 2025 • Strategic Risk: - City of London • Insurance in India • Portfolio risk • MAN group SAMI Consulting 2006

  31. The end www.samiconsulting.co.uk Future proofing – robust decisions in times of change SAMI Consulting 2006

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