The Need for Frequent Stress Testing

Apr  14 
Danny Baker  Vice President, Market Strategy, Fiserv 

Analyzing what-if scenarios enables strategic, proactive decisions

For many, the financial effects of COVID-19 are reviving ghosts of the 2008 recession that slammed the economy and shuttered some of the world's biggest banks. Following that crisis, regulators demanded rigorous stress testing from financial institutions. As a result, our biggest banks are now better equipped to cope in a downturn.

But risk still looms. And financial institutions can't afford to wait and see how developments will affect their portfolios. To be effective, stress testing needs to be frequent and comprehensive, as our current situation has made clear.

Survive and Thrive

During turbulent times, financial institutions need agility and flexibility, which requires being able to see a way forward through quickly evolving challenges.

Risk-management tools can help financial institutions analyze extreme, once-in-a-lifetime scenarios and make the right strategic decisions, right now. Banks and credit unions can model scenarios against endless what-if combinations to find the most desirable courses of action. If a situation changes, they can rerun their assessments.

Risk-management tools can help financial institutions analyze extreme, once-in-a-lifetime scenarios and make the right strategic decisions, right now.

Recalibrate Risk, Right Now

In typical scenario planning, analysts create a narrative and then play with causes and effects to determine the most desirable outcomes. Most financial institutions rely on their deposit and loan business to make money, so stress tests often quantify the effects of interest rate changes or related interventions. In those models, analysts rely solely on the past to forecast the future.

While hindsight may be 20/20, no two situations are identical.

In addition, most financial institutions perform scenario analyses quarterly, running through fairly straight-forward stimuli. Those forward-looking scenarios aren't calibrated for extreme events such as the current pandemic. In today's situation, interest rate is just one of many variables to be considered.

In times of massive change and uncertainty, financial institutions need to quickly understand how to limit their exposure. Quarterly analyses now offer too little insight, too late.

Modeling helps financial institutions visualize the outcome of price changes, sell-offs or long-term delinquencies – and proactively protect customers, members and the institution.

What If?

It's best to run scenarios through risk-management systems now to find out what would happen in unusual circumstances. What if the Federal Reserve considers negative interest rates? What if borrowers stop making, or defer, loan payments? What if loan refinancing and restructuring skyrocket?

Risk-modeling tools can integrate endless variables, such as interest rates, contingent liquidity and duration. And the tools are adaptable, so you can create and test new scenarios as soon as situations change.

Stress-test tools are invaluable for calculating how income streams, liquidity and capital might be affected if market disruption continues for two weeks, a month or much longer. Risk-modeling tools help financial institutions proactively address threats across the business.

Secure Your Own Future

Many financial institutions rely on external companies to run stress-test scenarios. For quarterly risk reporting, that's certainly adequate. But in a crisis, you could be putting your future into someone else's hands.

Regulators point to scenario-based testing's limits, noting many institutions rely on patchy data or fail to involve a broad enough spectrum of the business. Bringing risk-modeling activities in-house clears some of those blind spots.

Nobody knows your business better than your executive team. Senior leaders have enterprise-wide visibility and are best equipped to identify, model and plan for worst-case scenarios.

Your executive team can quickly respond when market influences change – sometimes by the hour – and as new risk models are developed. Each risk assessment deserves discussion, evaluation and disciplined action based on the modeled outcomes. Because senior leaders will be the ones making hard decisions based on data, they should play an active role in the risk-modeling process.

Expect the Unexpected

In uncertain times, financial institutions need to stay nimble and alert. Risk-modeling tools can help them prepare for and stay ahead of massive changes and longer-term effects.

With the right tools, financial institutions can, in fact, expect the unexpected.