One of the fundamental forces propelling stress testing is that previous control methods have been subject to standards fatigue. This term means they are no more effective because they have been left behind by innovation in industry sec- tors, all the way from financial instruments to technological products. To help appreciate this point, let’s take as an example:
● Internal control standards, and
● The system of limits in the banking industry.
Readers will recall from previous discussions that the basic role of internal con- trol is to provide management with clear feedback signals about what is going
both right andwrong within the enterprise.4 Up to a point, but only up to a point, internal control and auditing procedures overlap, but in the general case they cannot be confused with one another, even if only for the reason that:
● Internal control is steady and holistic
● While auditing digs deep, is intermittent, and often proceeds by sampling inspection.
One of the prudential standards often used in internal control is the system of limits. Some banks, however, have, unwisely, substituted limits by value at risk (VAR), which is absurd. Leaving aside that VAR is an incomplete and obsolete standard,5 its use for VAR has been established by the regulators for a sort of order of magnitude reporting on exposure.
By contrast, internal controls and the system of limits are put in place by the institution. The system of limits is not intended to reduce risk in an abstract or order of magnitude sense. Its goal is the steady and dependable:
● Measurement and
● Pricing of risk.
In a similar manner, the real objective of risk management standards is neither to eliminate failures of individual banks nor to abolish the process of creative destruction that provides the market with its dynamism. Risk measurement and risk-based pricing are important prudential standards which must continue to evolve in order to bite. Beyond this,
● They are not intended to replace individual responsibility, and
● Their purpose is to contribute what it takes to enhance it.
Within this frame of reference, IFRS must be seen as an accounting standards renewal which helps both risk management and risk-based pricing. Guidelines related to risk management and capital adequacy do not mean much in the absence of sound accounting conventions (see Part 1), dependable valuation of assets (see Chapter 10), robust auditing practices (see Chapter 17), and a timely, focused system of internal controls. Precisely for these reasons:
● Stress testing is an integral part of the system of rigorous management con- trols, and
● Increasingly more powerful and more scientific stress tests must match the rate of innovation, to avoid severe financial crises.
Globalization increases the need for stress tests. Efforts aimed at improving financial stability are more likely to be effective if they can test a priori the after- math of market forces, harness the prudential instincts of serious market players, and promote a code of market practices by providing benchmarks on which prac- titioners can depend.
Not only in banking but throughout industry, financial innovation means that attaining the objective of sound governance requires a steady evolution of methods and standards. Precisely for this reason, tools, methods, and standards for risk con- trol are no longer as simple as they used to be. The complexity of the financial sys- tem makes a simplified approach lightweight, a reason why risk management must:
● Take account of multiple specific requirements, and
● Aim to avoid standards fatigue by means of steady evolution.
Such evolution should be cultural, conceptual, and pragmatic – and this is what stress testing is all about. Properly executed stress tests can be instrumental in convincing economic agents that they will not be protected from the conse- quences of adverse outcomes because:
● ‘This’ or ‘that’ exposure has outgrown its original limits
● While credit risk is on the increase, many banks bend their credit stan- dards and do not respect them, or
● Too many derivatives contracts have turned sour, pulling hedge funds down with them (see Chapter 1).
The many aspects of the financial infrastructure must work in unison to provide the input necessary for effective risk control. Accounting conventions, auditing standards, and reliable financial reporting are not discrete islands but part of the same system.6They are internal prerequisites to sound governance, while other prerequisites are external.
Another internal prerequisite is the development of more sophisticated tools and methods. This is often handicapped because of algorithmic insufficiency. The term means that the algorithmic approaches we are currently using are no longer able to serve risk management problems of the magnitude with which we are confronted today. (This evidently applies also to the VAR model.) Much more powerful methods and tools are necessary:
● Experimental design helps in investigating contemplated solutions, and
● Stress testing makes feasible the hunt for outliers.
The management of risk connected to derivatives is an example where algorith- mic insufficiency has made itself felt. Theoretically, derivative financial prod- ucts are used by banks and other institutions to limit risk concentrations in their portfolios. Practically, indeed most often, they reach the opposite result leading to concentration of exposure. Only the best governed entities appreciate that one of the major problems with innovative financial instruments is that they have not been fully tested under adverse circumstances.
Stress tests for liquidity provide an example. Usually contracted over the counter, derivatives are instruments having questionable liquidity under virtu- ally all circumstances. This runs contrary to the principle that capital markets need liquidity for timely settlement of their obligations. Hence, the need for steady stress testing liquidity positions.7
● Estimates of value at risk based on historical price volatility are not a good guide to potential losses under nervous markets, and
● Liquidity in the underlying markets can dry up unexpectedly, leaving eco- nomic agents more exposed than they expected to be on the basis of esti- mates by classical models.
Therefore, it is no surprise that well-managed institutions look at stress testing as a way to overcome these limitations. Testing the long leg of risk distributions plays an important role in identifying potential vulnerabilities and in supporting senior management’s efforts to deal with them. Survival requires spotting gaps in the institution’s financial staying power ahead of the curve. This is one more rea- son why stress testing should be an integral part of enterprise risk management.