Stress testing: what it is and how it helps in the COVID-19 crisis

What it is about

Stress testing is a core methodology for risk management and for the soundness of institutions’ financial resources: it makes it possible to identify and quantify the impact of different scenarios on their future financial expectations.

The speakers, José Manuel Desviat, Juan Carlos Estepa and Omar Bairán, discuss how international banks use it in their internal management: to get a global view of the institution’s risk, report to the board and senior management, and assess regulatory solvency. They point out that building a stress testing framework raises challenges in methodologies, risk processes and information systems, and that quantitative models must be backed by expert judgment, a risk culture and sound internal governance.

Session summary

The first speaker explains what stress tests are: a risk management technique that simulates the impact of an unfavorable but plausible scenario on results and solvency, ranging from sensitivity analysis to scenario analysis. He reviews its origin in market risk, the boost it received with the 2008 crisis and Basel’s principles for its governance. He argues that risk should be managed with a forward-looking view and not only by looking at the past, and that results must be built into the risk appetite framework (appetite, tolerance and capacity, with early warnings), strategic planning, the capital and liquidity self-assessment and the recovery plan. He insists on choosing scenarios that target each institution’s real vulnerabilities.

The second speaker takes the topic to the context of the pandemic and the Dominican Republic. He sets out the dilemmas of running stress tests in the middle of a crisis, the operational risk from infections and fraud, and why it is worth estimating where we stand today (‘nowcasting’) with panel data, filters and simple epidemiological models. He shows applications of principal component analysis to a sector-level systemic risk index and to an investment portfolio, where he concludes that a short history does not produce truly stressed scenarios, and examines the effect of the peso’s devaluation and how it is transmitted to credit, market and operational risks. The questions covered the risks in defining scenarios and how to adjust them to the evolution of infections.

Topics covered

• What a stress test is and the difference between sensitivity and scenarios
• Basel principles and governance of stress tests
• Integration with risk appetite, strategic planning and capital self-assessment
• Scenario design: own vulnerabilities, historical and idiosyncratic
• Pandemic and estimating the starting point with nowcasting
• Principal components: systemic risk and stress of an investment portfolio
• Peso devaluation and transmission to other risks