Book 4. Valuation and Risk Models

FRM Part 1

VRM 8. Stress Testing

Presented by: Sudhanshu

Module 1. Stress-Testing Integration And Methods

Module 2. Stress-Testing Governance

Module 1. Stress-Testing Integration And Methods

Topic 1. Stress Testing vs. Other Risk Measures

Topic 2. Stressed Risk Metrics (Stressed VaR & Stressed ES)

Topic 3. Key Aspects of Stress Testing

Topic 4. Reverse Stress Testing

Topic 5. Regulatory Stress Testing

Topic 1. Stress Testing vs. Other Risk Measures

  • Purpose of Stress Testing:

    • Assess an institution’s ability to withstand rare but severe adverse events.

    • Acts as a forward-looking complement to risk metrics like VaR and ES.

  • Comparison with VaR and ES:
    • VaR/ES: Estimate potential loss under normal conditions.
    • Stress Testing: Focuses on non-normal, extreme events.
    • VaR answers: What is our expected loss at a given confidence level?
    • Stress testing answers: What if a major crisis happens tomorrow?
  • ​Enterprise-wide use:
    • Integrates across business lines and risk types (credit, market, liquidity).
    • Reveals vulnerabilities not captured by backward-looking measures.

Practice Questions: Q1

Q1. Each of the following statements accurately reflects why stress testing is an appropriate risk management tool except:
A. normal market conditions can present a false sense of security.
B. the extreme scenarios that are modeled are unlikely but still possible.
C. extreme events tend to have a high probability of occurrence with a moderate impact.
D. an institution must have sufficient liquid assets and capital to survive an extreme event.

Practice Questions: Q1 Answer

Explanation: C is correct.

Extreme events tend to have a low probability of occurrence with a high impact.
Stress testing is designed to show how an institution will respond to these types of events and ensure that they have enough capital and liquid assets to manage during these times.

Practice Questions: Q2

Q2. Relative to other measures of risk, stress testing is more likely to:
A. use relatively short time horizons.
B. capture both positive and negative events.
C. capture a large number of extreme scenarios.
D. be forward-looking without providing probabilities for loss distributions.

Practice Questions: Q2 Answer

Explanation: D is correct.

Stress tests are forward-looking and do not provide probabilities for loss distributions. The time horizons are typically long, only negative events are captured, and the number of extreme scenarios tends to be relatively small.

Topic 2. Stressed Risk Metrics (Stressed VaR & Stressed ES)

  • Definition: ​Uses historical data from known stress periods (e.g., 2008, 2020).

  • Advantages:
    • Conservative risk measure.
    • Forces institutions to overprepare for worst-case scenarios.
    • Encourages capital buffers for resilience.
    • Useful for capital planning and regulatory compliance.
  • Disadvantages:
    • Not responsive to current market conditions.

    • Cannot derive loss probabilities.

    • Limited backtesting feasibility due to rare event modeling.

  • Comparison:
    • Traditional VaR/ES: Broad, probabilistic risk estimates.
    • Stressed metrics: Focused, conditional, scenario-based estimates.

Practice Questions: Q3

Q3. Which of the following key variable inputs is least likely to be incorporated into stress-test models?
A. A 5% decrease in the stock market.
B. A decline in GDP of 300 basis points.
C. An increase in interest rates of 300 basis points.
D. A 5% increase in the national unemployment rate.

Practice Questions: Q3 Answer

Explanation: A is correct.

A 5% decrease in the stock market could easily occur over the course of a few trading sessions and is not as likely to be included in stress-test models as a 300 basis point decline in GDP, a 300 basis point increase in interest rates, or a 5% increase in the unemployment rate.

Practice Questions: Q4

Q4. Which of the following statements most likely describes an advantage of using stressed risk metrics?
A. The risk metric will be more realistic.
B. The risk metric will be more conservative.
C. The risk metric will mirror the portfolio returns.

D. The risk metric will respond to current market conditions.

Practice Questions: Q4 Answer

Explanation: B is correct.

A key advantage of using stressed risk metrics is that they are conservative. In examining capital adequacy for unexpected losses and considering stressed metrics, the amount of capital is likely to be more than sufficient.

In other words, a risk metric that is stressed is likely to be more conservative. A more conservative risk metric does not necessarily mean it is more realistic. One of the disadvantages of using stressed inputs is that the risk metric becomes unresponsive to current market conditions and is more dependent on the investments within the portfolio.

Topic 3. Key Aspects of Stress Testing

  • Scenario Development:

    • Time Horizon: 3 months to 2 years, depending on impact duration.

    • Historical Scenarios: e.g., Lehman collapse, 2020 pandemic.

    • Hypothetical Scenarios: e.g., political instability, cyber-attack.

  • Variables Stressed:

    • Interest rates, FX rates, GDP, unemployment, equity/commodity prices.

  • Modeling Approach:
    • Core Variables: Main drivers of risk (e.g., credit spreads).
    • Peripheral Variables: Secondary factors (e.g., sector indices).
  • Knock-On Effects:
    • Cascading consequences, e.g., funding freeze after counterparty failure.
  • Frequency:
    • Routine (monthly/quarterly) and Ad Hoc (event-driven).

Topic 4. Reverse Stress Testing

  • Definition: Identifies the combinations of risks or events that would lead to institutional failure.

  • Purpose: Uncovers hidden vulnerabilities and systemic weaknesses.
  • Approaches:
    • Historical Amplification: Intensifying past crisis conditions.
    • Factor-based Modeling: Simulating failures through drastic parameter shifts.
  • Outcome:
    • Enhances risk awareness.
    • Drives strategic contingency planning.
    • Often a regulatory requirement for systemically important institutions.

Practice Questions: Q5

Q4. Which of the following reasons best explains why institutions use reverse stress tests?
A. To identify liquidity risk.
B. To identify risk concentrations.
C. To assess where multiple risks occur simultaneously.
D. To test events that threaten the viability of the institution.

Practice Questions: Q5 Answer

Explanation: D is correct.

Institutions use reverse stress tests to assess the events that are outside of normal business expectations and could threaten the institution’s viability.

Topic 5. Regulatory Stress Testing

  • Regulatory bodies such as Federal Reserve also conduct stress tests:
    • Comprehensive Capital Analysis and Review (CCAR): Assets> $50B
    • Dodd-Frank Act Stress Test (DFAST) -  $10B<Assets<$50B
  • Scenario Types:
    • Baseline: Expected economic conditions.
    • Adverse: Moderate downturn.
    • Severely Adverse: Worst-case scenario (e.g., GDP crash, 10% unemployment).
    • Internal: Designed by individual banks.
  • Objectives: Assessing capital adequacy and ensuring systemic stability.
  • Consequences of Failure:
    • Capital distribution restrictions.
    • Mandated capital raising.
    • Increased regulatory scrutiny.

Module 2. Stress-Testing Governance

Topic 1. Responsibilities of the Board of Directors

Topic 2. Responsibilities of Senior Management

Topic 3. Role of Internal Audits

Topic 4. Policies, Procedures, and Documentation

Topic 5. Validation and Independent Review

Topic 6. Basel II Stress-Testing Principles

Topic 1. Responsibilities of the Board of Directors

  • Accountability: Ultimate responsibility for firm’s risk strategy and stress testing framework.
  • Risk Oversight:
    • Set risk appetite and approve stress-testing policies.
    • Must challenge management assumptions and results.
  • Decision Making: Use stress test outputs to:
    • Monitor early warning signs.
    • Influence strategic direction.
    • Adjust capital and liquidity buffers.
  • Independence: Should not be involved in execution but must be knowledgeable enough to evaluate.

Topic 2. Responsibilities of Senior Management

  • Implementation Role: 
    • Accountable to the board.

    • Responsible for the satisfactory implementation of the stress-testing activities authorized by the board.

    • Develop, implement, and maintain stress-testing framework.
  • Activities:
    • Coordinate scenario design.
    • Benchmark results against internal/external standards.
    • Identify gaps or weaknesses in models or data.
  • Communication:
    • Provide clear and detailed reports to the Board.
    • Document limitations and assumptions used.
  • Adaptation:
    • Regularly update tests for evolving risks.
    • Incorporate feedback from audits and regulators.

Practice Questions: Q6

Q6. Which of the following statements about governance structure is accurate?
A. Senior management has ultimate oversight responsibility and accountability for an entire institution.
B. The board of directors has responsibility for implementing authorized stress-testing activities.
C. The board of directors can change an institution’s capital levels and exposures following a review of stress-test results.
D. Senior management should use scenario analysis, not stress testing, to evaluate an institution’s risk decisions.

Practice Questions: Q6 Answer

Explanation: C is correct.

Stress testing can serve as an early warning sign of upcoming pressures and risks. The board of directors can take actions that include adjusting capital levels, increasing liquidity, adjusting risks, or engaging in or withdrawing from certain
activities.
The board of directors has ultimate oversight responsibility and accountability for an entire institution. Senior management is responsible for implementing authorized stress-testing activities. Senior management should use stress testing, complemented with scenario analysis, to evaluate an institution’s risk decisions.

Topic 3. Role of Internal Audits

  • Governance Role: Independent verification of the integrity and compliance of stress-testing activities.
  • Scope: Evaluate
    • Frequency and adequacy of model usage.
    • Documentation process.
    • Expertise of staff.
  • Value Added:
    • Uncovers inefficiencies, misapplications, or weaknesses.
    • Recommends corrective actions to management.
  • Required Traits: Impartiality and sufficient technical expertise.

Practice Questions: Q7

Q7. Which of the following statements best reflects the responsibilities of an internal audit?
A. An internal audit should not assess the staff involved in stress-testing activities.
B. An internal audit must independently assess each stress test used.
C. An internal audit should review the manner in which stress-testing efficiencies are identified and tracked.
D. The internal audit function needs to be impartial but does not need to be independent.

Practice Questions: Q7 Answer

Explanation: C is correct.

An internal audit should review the manner in which stress-testing efficiencies are identified, tracked, and remedied.
An internal audit should assess not only the stress-testing activities, but also the staff involved in stress-testing activities. An internal audit does not need to independently assess each stress test used. The internal audit function needs to be independent and objective.

Topic 4. Policies, Procedures, and Documentation

  • Core Elements: Purpose, roles, responsibilities, frequency, documentation, escalation protocols.
  • Transparency: Ensure clarity for internal teams and external stakeholders (auditors, regulators).
  • Consistency: Enable standardized application across business units.
  • Use Cases:
    • Track results over time.
    • Evaluate effectiveness of mitigation strategies.
  • Best Practices: Include documentation of 3rd party tools, scenario logic, and key assumptions.

Practice Questions: Q8

Q8. Which of the following statements about documentation of stress tests is most appropriate?
A. Institutions are not concerned if their vendors document stress-testing activities.
B. Institutions should incentivize documenting stress tests to increase efficiency.

C. Documentation is not useful for stress-test developers, but it is important to senior management.
D. Documentation should not include a description of the types of stress tests and methodologies, but it should include a description of the key assumptions and limitations.

Practice Questions: Q8 Answer

Explanation: B is correct.

Institutions should offer incentives for documenting stress tests to ensure that documentation is effective and complete. Institutions should ensure that other market participants, including management, vendors, and reviewers, adequately document their stress-testing activities. Documentation is useful for both stress-test developers and senior management. Documentation should include a description of the types of stress tests and methodologies, as well as a description of the key assumptions and limitations.

Topic 5. Validation and Independent Review

  • Purpose: Ensuring that governance includes ongoing validation and independent review of stress-testing activities.
  • Validation Components:
    • Theoretical justification
    • Judgmental assumptions
    • Qualitative elements (e.g., scenario selection)
  • Challenges:
    • Rare nature of stress events limits empirical testing.
    • Must account for increased correlations, lower recovery rates, etc.

  • Recommendations: Use multiple models to capture a range of plausible losses.

Practice Questions: Q9

Q9. Which of the following actions is least likely a component of the validation and independent review of stress tests?
A. Using expert-based judgment.
B. Testing data during nonstress periods.
C. Communicating stress-test results to all stress-test users.
D. Reviewing the qualitative but not the judgmental aspects of stress tests.

Practice Questions: Q9 Answer

Explanation: D is correct.

Validation and independent review of stress tests includes a review of both the qualitative and judgmental aspects of stress tests.
Validation and independent review of stress tests should also use expert-based judgment, test data during nonstress periods, and involve communication of stress-test results to all stress-test users.

Topic 6. Basel II Stress-Testing Principles

  • Issued by: Basel Committee on Banking Supervision (2009, updated in 2018).
  • Key Principles of Stress Testing frameworks:
    • Clear, formal objectives aligned with overall risk management.
    • Effective governance structure.

    • Stress testing should be used as a risk management tool and to inform business decisions.

    • Capture material and relevant risks.

    • Resources and organizational structures should be adequate.

    • Use of granular data and robust IT systems.
    • Fit-for-purpose models and methodologies.
    • Subject to challenge and regular review.
    • Communicate findings within and across jurisdictions.
  • Strategic Role: Supports liquidity planning, capital allocation, risk mitigation, and transparency.

Practice Questions: Q10

Q10. Which of the following statements accurately reflects a Basel Committee stress-testing principle?
A. Stress-testing models should be reviewed at least twice per year.
B. Stress-test results should not be communicated beyond senior management and the board.
C. The risk captured in a stress-testing framework should be comprehensive, ranging from mild to extreme.
D. Stress-testing framework objectives should be aligned with the overall risk management​ framework.

Practice Questions: Q10 Answer

Explanation: D is correct.

Stress-testing objectives should align with the overall risk management framework for an institution. There is no requirement that the models should be reviewed twice per year. Results should be communicated beyond just senior management and the board. Mild risks are not what stress testing is intended to capture; risks should be extreme.