WHY ONE DIMENSIONAL STRESS TESTING NEEDS TO BE REINVIGORATED: TAKING A DUAL-TIME DYNAMICS APPROACH

Hugh Morris, VP for Banking and Financial Services, Genpact

Banks are required to perform stress testing to ensure they are holding adequate quantities of capital to offset the effects of downturn events and potentially catastrophic losses that may arise from global crises.

British banks, including Barclays, Royal Bank of Scotland, and Lloyds will be subjected to stress tests this year, making up the 124 banks across the European Union. The aim is to reinstall consumer and business faith in the financial system following the global financial crisis of 2008 at both a system-wide and individual-institutional level.  The objective of the stress test results, presented in October of this year, will be to bolster public confidence in the stability of the system and demonstrate that bank can withstand a range of severe traumas devised by the banking authorities.

Previously, stress tests have been criticised for not being comprehensive enough, with most contemporary practices limited to one dimensional calculations. Scenarios under this system are based on values of exogenous macroeconomic variables, which fail to consider the impact of other endogenous risk factors.

A new method of stress testing optimises the process, combining the impacts of natural portfolio dynamics and macroeconomic performances to model and subsequently predict the portfolio performance. ‘Dual-time dynamics’ assess risk on both independent and dependent variables for example, a global economic downturn vs. a seasonal, yearly event such as Diwali.

A superior level of modelling is introduced as part of this approach, where customer time and age in the portfolio are considered to be additional endogenous characteristics contributing to portfolio performance.

Let’s now focus on some markets that will involve stress testing. As part of a European Union-wide test this year, The Bank of England will test whether lenders can adequately withstand a shock to the property market. It has emerged that buyers are spending a higher proportion of their incomes on mortgages than at any time since 2005.  We are seeing a tougher home loan underwriting process and UK lenders being required to adopt more rigid practices when assessing prospective borrowers’ mortgage applications, which can involve dissecting income and bank statements.

It’s not only the West that requires stress tests. It has been reported that the China Banking Regulatory Commission (CBRC) has announced that it will conduct regional and national stress tests after banks saw a spike in bad loans last year. Chinese banks are reeling from the aftermath of a huge lending binge that policymakers unleashed to soften the impact of the global financial crisis in 2008. The CBRC guidelines have stated that it’s important that banks do not hide from the true scale of their exposure to bad loans by offering new ones. Banks should instead analyse the risk within each key region, focusing on certain industries and clients.

That being said, a discrepancy in stress testing has been identified by some analysts in the US who believe that even with the new measures being put in place across Europe, the European banks would still not be comprehensive enough to withstand US tests. The difference in approach to stress testing has been viewed as the result of a key difference in the make-up of the Euro Zone and US economies. U.S. banks make up a greater percentage of the U.S. economy whereas this is smaller in Europe.  However, it will be difficult to measure how tough the stress tests are until they are completed and US stress tests provide valuable information for European market participants identifying where any lessons can be learnt.

It’s therefore essential that banks from both the West and the East use the right strategies to stress testing. If they are to engage in supporting World economic growth, a holistic and comprehensive ‘Dual-Time Dynamics’ approach must be deployed.