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Stress Testing: An Approach to Making Forward-looking and Objective Scenarios Deloitte Touche Tohmatsu LLC Tsuyoshi Oyama This paper does not include the official view of Deloitte Touche Tohmatsu LLC but only reflects the lecturer’s own opinion. Post-crisis Stress Testing -- Required Elements Required elements Deep involvement of board and senior management Clarification of degree of stresses Transparent and accountable process of stress testing Forward-looking scenarios Objective scenarios Dynamic scenarios Comprehensive scenarios based on root causes Use of the outcome of stress testing for business strategy as well as risk management Flexible update corresponding to changes in external environments Elements required for stress conditions Elements required for scenarios Consistency with Management’s risk appetite Objective Exceptional but plausible scenarios Dynamic Forward-looking Comprehensive Macro perspective Firm-wide scenarios Market micro structure perspective 2 Elements required for the use of stress testing Effective integration into risk management and business judgments Transparent and accounting process A Way of Making Stress Scenarios 1/2 (Step 1) Scenario conditions 1.1 Determine the degree of stresses (severity and frequency) to be assumed in stress scenarios in line with risk appetite of senior managers 1.2 Identify all important risk factors for own portfolio and pay higher attention to the scenarios that could impact them significantly (Step 2) Prepare the tools to make forward-looking scenarios 2.1 Make several enterprise-wide forward-looking stress scenarios using, for example, the following tools 3 Several early warning indictors of banking crisis to select the scenarios The future event database that controls the flood of information of emerging stress events from international/national agencies, media, academics, etc. on timely manner The stress event database that comprises big stress events in the past, of which causes and root causes are analyzed and categorized for supporting the scenario-making Global macro economic modeling techniques that forecast the development of macro-economies of major countries under the certain scenarios over the coming 2-3 years A Way of Making Stress Scenarios 2/2 (Step 3) Determining forward-looking stress events 3.1 Confirm the countries with high probability of banking crisis using the early warning indicator 3.2 List up 4—5 stress scenarios highlighted by the market, regulators, media and academics using the future event database and the information of 3.1 and 3.2 3.3 Narrow down the number of stress scenarios by using the conditions identified by Step 1 3.4 Determine the severities and frequencies of stress scenarios based on the risk appetite confirmed by Step 1 (Step 4) Narrating the stress scenario stories 4.1 Make the stories of stress scenarios using the stress event database 4.2 Determining the paths of macro-economic indicators of major countries over the coming 2-3 years under the stress scenarios using the global macro-economic modeling techniques (Step 5) Translating the macro stress scenarios into risk parameter 5.1 Translate macroeconomic indicators assumed under the stress scenarios into risk parameters 5.2 Identify the impacts of stress scenarios on FIs’ portfolios 4 Example 1 Early Warning Indicators This tool is expected to enhance forward-looking, objective and macro-oriented scenarios The case of early warning indicators of financial crisis occurring in a major country International and national agencies, as well as academics have already developed various early warning indicators relating to financial crisis, which will be used These indicators Identify the region(s) with probability of crisis occurring above a certain threshold Crisis prob. 1 Crisis pro. 2 Japan 16.2 27.3 US 29.5 15.7 UK 15.5 22.2 EU 35.6 43.2 Check! China 23.1 34.2 Check! Korea 25.6 12.2 LA 17.8 22.5 Others … … Input data Macro economic imbalance Bank lending Asset prices Financial system stability Market liquidity Exchange rate 5 Example 2 Global Risk Heat Map based on the Future Event Database This tool is expected to enhance forward-looking, objective, comprehensive and macro-oriented scenarios Changes in future event heat map (From August to September 2010) US Real economy EU China WEO (April): Worsening fiscal balance, BOJ Outlook (April): Historically high level of public debt Media: Frequent negative comments ECB (June): Funding cost hike due to the sovereign crisis Sovereign Japan Asia Others Scenario 2: Euro crisis ⇒a little moderated Scenario 3: China bubble bursting ⇒no change Scenario 4: JGB bubble bursting ⇒no change New scenario? ⇒Basel III shock scenario GFSR (April), ECB (June), BOJ/FSR (March): Increase in Sovereign risk WEO (April): Sovereign risk, Rewinding leverage and Stabilization of CDS spreads Banking system WEO (April): Emerging risk of holding government bonds Financial market ECB (June): Risk of interest rate hike due to widening fiscal deficit GFSR (April): Roll-over of banks’ short-term debts Media: Banks credit crunching Media: Pressures on Renminbi appreciation Ex market BOJ FMR (July): Yen appreciation Stock market BOJ FMR (July): High volatility due to the Yen’s appreciation Media: Pressures on currency appreciation GFSR (April): Asset bubbles BOJ Outlook (April) Asset bubbles BOJ FSR (March): Deteriorating quality of commercial mortgage loans Credit Media: Export limits on wheat/ Russia Commodity Bank regulation 6 Scenario 1: US economy double dip recession ⇒probability increases WEO(April) : Capital inflow GFSR (April): Inflation BOJ Outlook (April): Decaying the fiscal stimulus impacts GFSR (July), BOE (June): Repercussion of emerging sovereign risk Real estate Media: Basel III framework set, discussions on capital surcharge for SIFI Dodd-Frank EU/UK regulations Example 3 Stress Event Database 1/2 This tool is expected to enhance objective, dynamic and macro scenarios There were so many financial and economic crises in the past While the same event with the past could not occur, the events having similar elements with the past tend to occur repeatedly 7 Example 3 Stress Event Database 2/2 The trigger event, cause and root cause of each event are analyzed and classified into several categories so as to facilitate the process of making the scenarios with a modern combination of some elements of past crises Stress event DB structure 8 Example 4 Macroeconomic modeling This tool is expected to enhance objective, dynamic and macro-oriented scenarios Stock price Real GDP growth rate 4.0 1,500.0 3.0 1,400.0 1,300.0 2.0 1,200.0 1.0 1,100.0 1,000.0 0.0 2009 2010 2011 2012 2013 ▲ 1.0 900.0 800.0 ▲ 2.0 700.0 ▲ 3.0 600.0 2009 Baseline/Japan ベースライン(日本) Stress/Japan ストレス(日本) ベースライン(米国) Baseline/US ストレス(米国) Stress/US Long-term interest rate 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 2009 9 2010 2011 2012 2013 2010 2011 2012 2013 Example 5 Stresses associated with market micro structure This tool is expected to enhance objective and micro-structure based scenarios Fundamental Macroeconomic Causes Macro Market Micro-structure Unexpectedly immobilized position Market Crash Market liquidity evaporation Huge losses Delayed recognition of market position Market instability Market Micro-structure Micro 10 Fund-raising problem Unexpected correlation Typical factors behind historical huge losses of investment banks Example 6 Translation of the development of macro economic variables under the stress scenarios into risk parameters Estimating the effects of macro economic change on credit cost and credit risk: PD case Parameter Approach Some examples Direct Approach Directly adjust PD Indirect Approach Putting stress on migration matrices PD 【Concepts of PIT and TTC】 PIT (point in time) 債務者数 景 気 改 善 時 良 低 1 2 3 4 5 6 7 悪 8 格付 TTC (through the cycle) 債務者数 モ デ ル 構 築 時 景 気 悪 化 時 一定 良 低 1 2 3 4 5 6 7 8 好景気 一定 高 11 モデル構築時 高 実績デフォルト率 Putting stress on credit scoring 実績デフォルト率 不景気 デフォルト率 格付毎で安定 デフォルト率 景気により変動 債務者数 景気により変動 債務者数 格付毎で安定 Putting stress on financial data of each obligor ① Specification of the relationship between economic cycle/GDP growth rate and PD by industry ② Specific hypothesis in accordance with shock scenario (e.g., double the PD for lowly rated bonds, setting PD=100% for top X% of major client) ① First confirming the state dependency of rating migration and then applying the rating migration under economic downturn ② First estimating the relationship between credit scores and macro economic variables and then using the result to calculate PD under the stress scenario ③ First estimating the sensitivity of financial data of major obligors to main macro economic variables and then using this information to estimate the financial state of these obligors under the stress scenario