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Stress Testing – The Experian’s Approach

Carlo Gabardo
Senior Business Consultant
Experian

Why Stress Testing?

“Stress Testing” used to be a familiar term only to risk management professionals and practitioners. Following the recent financial crisis, stress testing has gained in popularity, with the results of stress tests conducted by the Regulators in the US and in the EU receiving significant interest from not only the global financial community but providing breaking news stories in the global media. Crucially, this crisis has illustrated that the amount of regulatory capital which is adequate to cover all the bank’s losses in “good times” can be completely inadequate under more extreme economic conditions.

As a result, Regulators have planned to implement a significant increase in banks’ minimum capital requirements and have set stricter requirements on which financial instruments are recognised as eligible capital. While the new “Basel III” regulations should be implemented in January 2013, national Supervisory authorities are paying increased attention to the mandatory stress tests which must be carried out regularly under the current Basel II rules.

Stress testing is defined by the Basel Committee as “a generic term describing various techniques used by financial firms to gauge their potential vulnerability to exceptional but plausible events”. In other words the purpose of stress testing is to ensure at all times that the bank’s capital is adequate to cover expected and unexpected losses even under stressed conditions.

Stress testing is not only a regulatory requirement used by the Supervisory Authority to assess the banks’ resilience to possible shocks, but also a critical risk management tool to help institutions to identify, assess and mitigate their risks (mainly credit risk but also liquidity risk, operational risk etc.), and is simply good business practice. Its role can be expanded further to serve as a business decision making tool (e.g. assessing new business activities, entering new markets, undertaking any strategic initiative, M&A). The very same stress testing techniques can also be used to forecast losses in the different phases of the trade cycle. Consequently, this allows for a more robust calculation and evaluation of provisions within the financial accounts, and provides a powerful forecasting tool to help financial institutions anticipate future trading conditions.

The need to develop a framework

For financial institutions, the development of a “Stress Testing Framework” is a crucial first step to meet the current and future regulatory requirements, as well as implementing best business practice. This means introducing a conceptual and organisational framework that encompasses all the phases of the stress testing process. This should include the actual organisational framework – “who does what?”; the theoretical framework – the definition of the approach the bank will follow and the assumptions that will be made; and the definition of the operational phase - what kind of stress tests will be executed, and how they will be carried out.

Having defined this framework, the bank can perform the actual the stress tests. These are “what-if” analyses whose final outcomes impact the financial risk metrics over a specific time horizon with differing degrees of severity. These scenarios should represent “exceptional but possible events” and should be applied to the different product segments of the portfolio (e.g. credit cards, mortgages, personal loans, SME) as well as to the whole portfolio itself. In practice, the additional risk (or stress) can be measured as the difference between the losses forecast under normal conditions (the “base case” which is used in the financial budget) and the hypothetical losses generated under the stressed scenario(s).

Experian’s Approach to Stress Testing

In response to the recent financial crisis, the increased economic and financial uncertainty and the development of a tighter regulatory environment, Experian has developed a sound and unique methodology to provide stress testing services to our clients across the globe, by combining the expertise of both Experian’s Decision Analytics and Economics Group.

Experian’s Economics Group has more than 20 years’ experience in global macroeconomic, regional and local area economic forecasting, while one of the core value propositions of Decision Analytics includes the design of the stress testing framework tailored to the specific client’s needs and the design and execution of the actual stress tests. To execute the tests Experian’s economists use their macro econometric, sectoral, regional and household models to forecast the movements in the main economic indicators (e.g. GDP, Income, Unemployment rate, etc.) under both base case and  alternative and extreme scenarios. These alternative economic values provide alternative values for the key risk metrics which imply different impacts on a client’s specific credit portfolios (e.g. expected increase in bad debt, change in the customers’ exposure etc.). The conclusion of the tests will be the measurement of the expected variation in the portfolio credit losses under all different scenarios.

Experian’s approach is based upon the understanding that to produce the most robust estimates of the impact of the economy on the portfolio requires using data at a disaggregated level. This means analysing the impact of economic stress not at the aggregate portfolio level but closer to the customer, as it is implausible to assume that all customers will display the same sensitivities to a given economic shock. Consequently, Experian looks to customer segmentation and to the use of regional and local area economic factors to better capture the impacts of economic shocks. Of course, as with all statistical work, the availability of data (both portfolio and economic) determines the optimal approach used.

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