Stress Testing

Pre Crisis and Post Crisis Differential

“We are seeing things that were 25-standard deviation moves, several days in a row”

To provide some context, assuming a normal distribution, a 7.26-sigma

daily loss would be expected to occur once every 13.7 billion or so years. That is

roughly the estimated age of the universe. Andrew G Haldane 13 February 2009

John Maynard Keynes’ famous maxim

“Better to be roughly right than precisely wrong!”

David Viniar Goldman Sachs CFO August 2007

Stress Testing a Historical Perspective

• Over Reliance of Regulators and Banks on VAR models that later proved to be inaccurate, stemming from models derived from the Stock Market Crash of October 1987 and the failure of Long Term Capital Management in September 1998

• Two Crises that were fundamentally different from the Great Recession

October 1987 Crash

• Emergence of VaR• In 1989, JP Morgan

Chairman wanted to know how much could “it lose if tomorrow turns out to be a relatively bad day”?

• VaR gained pre-eminence with the banking community, leading to the design and implementation of Basel 2.

Was VaR responsible for Meltdown?

• Between October 1998 and June 2007, Bank Balance Sheets trebled and their share prices increased almost 60 %.

• Belief in Risk Management, the new frontier in Risk Management was alleviating risk?

• As Galbraith noted innovation is not adjudged critically, every new “innovation” inevitably proves to be only a mild derivation from prior products, thus risk is masked.

NINJA Mortgage

• Classic Example of Asset that quickly became a liability, not much of an issue when prices were rising as Baker (Center for Economic and Policy Research, p. 18, ISBN 978-0-615-53349-0) notes that house prices were had increased by 30 per cent ahead of inflation from 1996 to 2002, which was considerably ahead of the long run average rate of increase

Diagnosing Market FailuresHaldane states that Market Failures Fall into 3 Categories

1. Disaster Myopia2. Network Externalities3. Misaligned Incentives

Disaster Myopia

• This is the mispricing of risk by financial institutions, as stated by Kahneman, Slovic and Tversky (1982)

• “It is well established in cognitive psychology that economic agents have a tendency to base decisions rules around rough heuristics or rules of thumb”

Network Externalities

• The “Contagion Effect”• Lehman Brothers collapse had a massive

contagion effect on the worldwide financial system leading to a collapse in World Interbank Markets.

• The Contagion Effect along with excessive Leverage could collapse a previously solvent institution

Misaligned Incentives

• Financial Innovation has lengthened the international chain from ultimate borrower to end Investor.

• A prime example of this was the setup of ACA Capital Management as an instrument for Paulson & Co. to short in the expectance of a collapse.

Hubris or Model Failure?

• “Caveat Emptor” those who took a contrarian position at a critical juncture reaped great rewards, as they resisted the overwhelming “Irrational Exuberance” and invested their funds accordingly.

• Not necessarily a “Model Failure” as the VaR assumptions based upon Probability of Default and Loss Given Default is fundamentally sound, but in this case was primarily affected by “Disaster Myopia”

Lessons Learned?

Haldane Suggests

1. Set The Stress Scenario2. Regularly Evaluate the Stress Scenario3. Assessment of the second-round effects of stress4. Translation of Results into firms liquidity and capital planning5. Fifth Transparency to regulators and Financial Markets

1.Setting the Stress Scenario

• Firstly the Regulators should set out an adverse economic situation sufficiently extreme to constitute a tail event

• This will enable banks to overcome Disaster Myopia

2. Regular Evaluation of Common Stress Scenarios

• Banks are now required to conduct regular evaluations of their positions relative to a set of common scenarios provided by regulators.

• We are already seeing this with the EU wide Stress Tests, Irish Prudential Capital Assessment Review

• Last Year Citigroup attempted to return Capital but was instructed to hold the capital in reserve by US Regulator’s

3.An Assessment of the Second Round Effects of Stress

• The common stress test as mentioned in Section 2, should be considered the starting point, in that their effect should be considered with respect to asset sales and liquiditiy and what Contagion Impact this could have on the banking system as a whole.

4.Translation of Results into Firms Liquidity and Capital Planning

• The results should be able to influence Management decision making and overcome internal incentive problems that need to be overcome.

5.Transparency to Regulators and Financial Markets

Stress Tests should clearly set out the stressed situation, the results and the resulting actions that need to be taken to

overcome potential liquidity or capital issues, this will improve transparency thus providing investors with a better snapshot, while increasing the authority of Risk Managers

Evolving Nature of Stress Testing

1. Credible Testing of Stressed Situations2. US Bank Stress Test’s conducted after the

Financial Crisis were instrumental in returning the institutions and subsequently the respective economy around, whereas the European Bank Stress Tests of 2011 were largely considered to be a Watershed.

Stress Testing

Financial Measures ProgrammeSingle Supervisory Mechanism

Financial Measures Programme 2011

• Aims to place the Irish banking system in a position where it can “fund itself and generate capital without undue further reliance” on the Irish or European public sectors.

• The FMP comprises 3 separate but complementary exercises:

– An independent loan loss assessment exercise performed by BlackRock Solutions (BlackRock), the results of which have informed the calculation of capital requirements under the PCAR.

– The Prudential Capital Assessment Review (PCAR), an annual stress test of the capital resources of the domestic banks under a given stress scenario, undertaken in order to calculate the cost of recapitalisation required to meet Central Bank-imposed requirements.

– The Prudential Liquidity Assessment Review (PLAR), which establishes funding targets for banks participating in the PCAR in order to reduce the leverage of the banking system, reduce banks’ reliance on short-term, largely central bank funding, and ensure convergence to Basel III liquidity standards over time.

Blackrock Loan Assessment

• Blackrock loan assessment exercise measured nominal loan losses banks might experience under base and adverse scenarios over 3 year (‘10-’13) and loan horizon timeline stretching out to 2040

• “Base scenario” in line with EU forecasts for Irish Economy• “Adverse Scenario” (i.e. stress scenario) represented a further

economic contraction

Projected Loan Losses

PCAR Stress Test

• Top down exercise which required banks to model the impact of certain assumptions on their balance sheets and profit & loss accounts

• Methodology closely in line with EBA stress test parameters thereby ensuring ensure capital requirements under PCAR would satisfy EBA standards

• Base case scenario assumed CET1 ratio of 10.5% and stress case 6%.• PCAR stress test relied heavily on Blackrock’s assessment of loan losses

and PLAR exercise• Additional buffers to ensure sufficient capital to cover post 2013 events

and contingencies also included• Attempt to estimate the effects of a severe but plausible macroeconomic

scenario and to size the level of capital injection that would enable banks to stay above the minimum level of solvency even under the assumed severe scenario.

PLAR

• Top-down exercise which required banks to meet a range of target funding ratios

• Central target is Loan to Deposit ratio which effectively meant the shrinking the balance sheets of relevant banks (i.e. Deleveraging)

• €72.6bn net loan deleveraging target for AIB, BOI, EBS & ILP in the period 2010-2013

• Range of assumptions in relation to funding used such as 0% max annual growth in deposits, how much growth could be achieved in wholesale funding markets and cost of funds projections.

PCAR Methodology

FMP 2011 Outcome

PCAR 2011 Review as at 30/6/2012

• In summary, included banks were “in aggregate and with all other things being equal” inside the stress case but outside the base case.

• Banks had recognised greater than expected base case loan losses and 63% of stress case loan losses.

• Performed better than expected in terms of projected deleveraging losses

Challenges Highlighted by 2012 Review

• Macroeconomic variables used in projecting base and stress scenarios generally came in somewhere between the two scenarios, however a number of variables (e.g. house prices, unemployment) were close to stress case.

• Pre provision and deleveraging operating profits of banks under PCAR projections for 2012 on annualised basis for 6 months to June 2012.

• New Central Bank guidelines issued post 2011 PCAR resulted in earlier recognition of losses/impairment charges relative to those assumed in 2011 PCAR.

• Ultimate judgement will have to come at end 2013.

Single Supervisory Mechanism

• Regulation came into force in November 2013• ECB, in conjunction with National Authorities, will carry out a

“comprehensive assessment” over a 12 month period prior to SSM coming into effect in November 2014

• Selection Criteria:• 3 largest banks in the country by assets• Asset size >€30 bn• Assets comprise more than 20% of country’s GDP.• Expected to cover c.130 financial institutions covering approx. 85% of euro

area bank assets.• Capital benchmark set at 8% of CET1 (i.e CET1 4.5%, 2.5% capital

conservation buffer and 1% add-on)

Methodology

Commentary

• “The exercise will be risk-based and selective, but at the same time we want to make sure that there are no nasty surprises in other parts of the balance sheet” Ignazio Angeloni, Director General Financial Stability ECB 23/10/13

• “Banks do need to fail to show its (the asssesments) credibility” Mario Draghi, President ECB, Bloomberg Television 23/10/2013

Conclusions

• Stress-Testing not a means in itself. Needs to be part of decision making process.

• Possible variables almost infinite.• Stress Testing is here to stay ad infinitum!

References

• Central Bank of Ireland, The Financial Measures Programme Report, March 2011• Central Bank of Ireland, PCAR 2011 Review, 2012• European Central Bank, Note on Comprehensive Assessment, October 2013• Financial Times 23/10/13