Capital stress testing scenarios and Swan Lake: Taking on the most fiendish of double roles

Mahim Mehra, Senior Risk Advisor, AxiomSL

When the great Russian ballerina Ana Pavlova made her American debut dancing the roles of the white and black swans Odette/Odile at the beginning of the 20th century, she caused a sensation. The technical and artistic demands required of dancing a ‘double role’ – such as the one required of the prima ballerina in Swan Lake – are a tall order that must have caused Ms. Pavlova a fair amount of stress indeed. But it seems that stress can be caused by more than just a stage performance in which swans are personified.

As the current global economic situation evolves post Covid-19, financial institutions are being forced to take a critical look at their capital stress testing practices and tackle a ‘double role’ of their own. While institutions simultaneously look back at what they have had to accommodate in past crises and look forward at how to predict where the global situation may be leading, they must aim to adjust their capital stress testing models accordingly, Mahim Mehra, Senior Risk Advisor, AxiomSL, argues.

Like knowing the dance steps, the need for stress testing is critical

In an ever-changing world, the need for stress testing scenarios, processes, and technologies that financial institutions can leverage is critical. They need to be equipped to prepare for systemic or idiosyncratic forces that can severely disrupt capital and liquidity management – as has been highlighted by the current global pandemic black-swan event. Financial firms must systematically address steps for building industrial-grade risk, liquidity, and capital stress testing processes because if they don’t know the choreography for a particular ballet, they are left dancing blindly while attempting to:

Implement best practices to bolster credit and market risk management capabilities

Understand capital conservation and countercyclical capital buffers in times of extreme economic stress

Extend connections across the management of operational, credit, and capital risks

Defining the role of capital stress testing: As elusive as playing the role of a swan?

How to accommodate factors such as changing definitions of default, the role of capital buffers and risk appetite when adjusting models, and important differences between point-in-time (PIT) model inputs versus through-the-cycle (TTC) should be explored within stress testing. However, with no exact historical precedent for the coronavirus black-swan scenario, institutions are left wondering if their current models, which are mostly based on IFRS 9 requirements, can accurately predict capital adequacy. They are asking themselves:

Can we monitor/configure/adjust our risk appetite accurately to account for both near-and long-term stress testing scenarios?

When will regulators halt payment moratoriums for consumers and how will this affect our capital adequacy?

We understand that expected credit loss (ECL) and risk will be most affected in current stress testing models, but what other calculations should we consider?

The big question is: how can we perform robust capital stress testing with any certainty in the current unpredictable economic environment?

While it may be tempting to talk about the year that was, this year is not over. Even as the curtain falls on the black swan Odile, Odette may have to continue to face the music given that it could be nearly impossible to predict whether the economy’s recovery will be V, U, L or K-shaped, or something else entirely.

A brief intermission for the ballerina to catch her breath: Capital buffer reprieves

Due to many coronavirus-driven regulation reprieves, the industry has gained some time to reflect on how best to address upcoming Basel IV requirements. Many concepts contemplated within the Basel framework can be implemented in capital stress testing processes taking future scenarios into account, including:

Capital conservation buffer – designed to avoid breaches of minimum capital requirements.

Countercyclical capital buffer – aimed to ensure that capital requirements consider the macro-financial environment.

During a crisis period, including the current one, a financial institution’s top line is stressed. At the same time, there is a hugely increased market demand for credit. Decisions by the European Banking Authority (EBA) and National Central Banks (NCBs) to provide fiscal or monetary help to the real economy translates into credit growth. Thus, financial institutions must provision for both buffers with stress scenarios and understand their impact in a challenging economic environment. This is especially true as moratoriums expire and institutions assess how credit deterioration will affect their capital adequacy, risk appetite, and business models.

Taking on Odette/Odile requires technical preparation and advanced artistry

Just as a ballerina does not arrive at the rank of ‘prima’ ready to take on fiendishly difficult roles such as Odette/Odile without a formidable technique, institutions will require robust preparation to take on black swans of their own. There are many elements to consider when establishing a comprehensive capital stress testing framework and given the additional element of accommodating the double role of historical look back and predictive future modelling, financial institutions are tasked with a tall order. Organisations should examine the following when building stress testing foundations:

Enterprise stress testing – to evaluate internal processes and better inform decision making for risk and capital adequacy

Tactical vs. strategic modelling – to use tactical expert judgment in model scenarios short-term, but integrate adjusted inputs and recalibrate models in the long-term

Model proliferation – to avoid a veritable model muddle and manage risk within a robust execution framework

When institutions can adequately assess the above factors and stress scenario influences, they are able to flexibly adapt their capital stress testing to the current situation and be prepared for the future, regardless of what type of swan appears on stage. At the end of her luminous dancing career during which she was inexorably linked to that most famous of double-swan roles, Ms. Pavlova said of the demands of the ballet, “to float so lightly about the stage is the hardest of labours”.

In a similar vein, effective risk management, liquidity and capital stress testing frameworks that can handle all varieties of swans will require a sophisticated artistry of their own.