Stress testing: risk and capital management

What it is about

José Manuel Desviat explained at the Second Annual Risk Conference (September 27, 2024) what stress tests are and how to integrate them into risk and capital management.

The 25 slides explain what a stress test is, its history and its use in supervision in Latin America and the Caribbean, its place in Basel (ICAAP and SREP), the difference between backward-looking and forward-looking risk management, integration with the risk appetite framework, the solvency projection process and the types of scenarios, including climate and reverse scenarios, and how to define a severe but plausible scenario.

Objectives

• Explain what a stress test is and what it is used for in risk and capital management.
• Show how stress tests are integrated with the risk appetite framework and strategic processes.
• Provide guidance on scenario design and defining severity.

Key takeaways

1. A stress test simulates the impact on earnings, liquidity or solvency of a hypothetical severe but plausible scenario; its scope, complexity and severity can vary.
2. Assessing capital adequacy only statically is insufficient: a forward-looking, scenario-based process is needed.
3. Stress test results are linked to the levels of the appetite framework: appetite target, early warning, tolerance limit and capacity limit.
4. Scenarios can be idiosyncratic or macroeconomic, historical, credit, equity, climate or reverse, which identify what extreme shock would compromise solvency.
5. The selection of scenarios must be subject to proper governance.