Stress testing techniques and best practices: A seven steps model

Implementing stress testing practices across the various bank divisions is a complex process. To address the need for an implementation framework, Moody’s has created a Seven Steps Model.

Our model represents a collection of principles and best practices developed through extensive interviews with many of the stakeholders in our client institutions. It also represents a process to implement a comprehensive, rigorous, and forward-looking stress testing program.

The findings are summarised in this article’s chart, which outlines how to perform stress testing and highlights key activities for each step in the process. 

Moody’s Has Created A Seven Steps Model To Help Implement Stress Testing Best Practices Across Various Bank Divisions.

Step 1: define scope and governance

Organizational silos make efficient enterprise-wide stress testing models an ongoing challenge. However, banks should establish dedicated teams tasked with defining objectives and governance guidelines and ensuring proper coordination among the business, risk, and finance departments. Such teams often range in size from three to 20 people (based on bank size). Some teams report to the Chief Risk Officer (CRO), others to the Chief Financial Officer (CFO); in both structures, a direct relationship with the board is critical.
 

Step 2: define scenarios with a multidisciplinary approach

Many banks use committees to define and review stress scenarios and to reinforce participation across institutional boundaries. Some organizations have created departments focused on the sole task of developing and managing enterprise stress testing. Such groups typically use external scenarios (such as macroeconomic shocks) as benchmarks that assist in developing specific internal scenarios. Moody’s recommends this as a best practice. Defining scenarios that are useful to business lines, as well as the risk and finance functions, requires the effective participation and cooperation of multiple teams and specialists.

Additionally, embedding risk culture in decision-making across business units and functions, while essential, remains a challenge when determining how to perform stress testing effectively.
 

Step 3: data and infrastructure

Institutions continue to struggle with data quality, availability, and comprehensiveness despite significant investments in both capabilities and infrastructure in recent years. Legacy systems and silos that were developed during Basel II implementation hinder the flexibility required for stress testing. Shifting and uncertain regulatory demands also complicate progress in this area. Therefore, it’s crucial to have a flexible platform for aggregating the balance sheet data that integrates information from across the organization.
 

Steps 4 & 5: calculate stressed key performance indicators (KPIs)

Once the data is captured and centralized, the next step is to layer on macroeconomic scenarios. Modelling the impact of macroeconomic scenarios on institutional cash flows (e.g., income or economic capital) requires both significant information and a strong understanding of the business drivers.

Quantitative measures — such as the probability of default (PD), exposure at default (EAD), and loss given default (LGD) — are of particular interest to senior management as they link stress testing directly to performance. Common implementation challenges include a lack of internal skills and data, a shortage of relevant resources, time constraints, and a dearth of skilled personnel. Best practices include developing internal models using dedicated quantitative teams; it’s also beneficial to use third-party models and services to accelerate the process, decrease internal workloads, and fill gaps in key skills and capabilities.
 

Step 6: reporting

Requirements for stress testing come from a variety of external and internal sources.  These include national and supranational regulators, the board of directors, various committee and governance structures, and business line management. These requirements will grow and evolve over time, making effective reporting consume an increasing amount of both time and resources.

Reporting tools that address regulatory requirements that can also be leveraged for business purposes will offer significant benefits and should be considered a best practice. At the same time, the lack of common standards for reporting means the size, degree of detail required, and structure of reports will vary widely, so flexibility and the ability to adapt to changing requirements are critical capabilities.
 

Step 7: action based on fully engaged senior management

Ultimately, effective stress testing must be part of both the business planning process and the institution’s day-to-day risk management practice. Adjustments to asset-liability composition should align with the management of concentration risk. Monitoring sensitive limits should provide useful input to risk appetite discussions. However, as requirements continue to change, best practices for stress testing remain a work in progress.
 

Conclusion

Investing in efficient tools, processes, and systems should help banks turn what is perceived as a labour-intensive, mainly regulatory exercise into an effective tool for business planning and risk management. Easier compliance with regulation and increased transparency in the marketplace should coincide with more confident decision-making.
 

Contributions

Charles Stewart and Nicolas Kunghehian also contributed to this article.

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