The disastrous financial crisis from 2007 – 2009, often referred to as the Great Recession, raised worldwide attention from banking regulators, urging them to improve their risk management tools to strengthen the resilience of financial institutions. Stress testing is one of the most important tools – first introduced in the Basel II capital framework – used to assess a financial company’s capital adequacy under adverse market conditions. Stress testing warns banks of adverse unexpected outcomes and provides an indication of how much capital is needed to absorb losses under economic downturn conditions. It is considered as a tool that supplements other risk management approaches and measures, thereby playing an important role in providing forward-looking assessments of risk and facilitating the development of contingency plans across a range of adverse conditions.
Despite these advantages, however, analysis of the financial crisis concluded that banks’ stress testing programs did not produce large loss numbers compared to their capital buffers or their actual loss experience. In response to this failure, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) introduced two distinct stress testing exercises, Comprehenseive Capital Analysis and Review (CCAR) and Dodd-Frank Act Stress Testing (DFAST) in order to enhance industry-wide capital planning practices.
The Dodd-Frank Act makes it possible for regulators to address systemic risk through capital requirements, for instance, by identifying a set of institutions as systemically important, and undertaking periodic stress tests to ensure these institutions are well-capitalized in aggregate stress scenarios. In contrast, the Basel III approach is more firm-specific and relies primarily on capital ratios, a capital conservation buffer and a countercyclical buffer. The stress testing of Basel III is at the bank level and does not subject the banking sector as a whole to a set of common stresses (as would be necessary for tying capital requirements to systemic risk).
Given the complexities of various interrelated stress testing rules, banking organizations need to work closely with their primary regulators and credible third-party vendors in order to successfully implement an effective stress testing framework which helps them plan for predictable and unforeseen capital and liquidity needs. Banks that must comply with multiple stress testing requirements have to develop an integrated and comprehensive stress testing framework that streamlines Dodd-Frank and Basel processes to reduce excessive and redundant work and to assess and manage their material risk exposures more effectively. Banks that successfully synergize all stress testing requirements will be able to convert a regulatory burden into a beneficial value-add for their businesses.