Stress Testing by Large Financial Institutions: Current Practice and Aggregation Issues

April 2000

Executive Summary

The activities of large, internationally active financial institutions have grown increasingly complex and diverse in recent years. This increasing complexity has necessarily been accompanied by a process of innovation in how these institutions measure and monitor their exposure to different kinds of risk. One set of risk management techniques that has attracted a great deal of attention over the past several years, both among practitioners and regulators, is "stress testing", which can be loosely defined as the examination of the potential effects on a firm's financial condition of a set of specified changes in risk factors, corresponding to exceptional but plausible events.

This report represents the findings of a Working Group on Macro Stress Testing established by the Committee on the Global Financial System. The group was asked to investigate the current use of stress testing at large financial institutions, in line with the Committee's overall mandate to improve central banks' understanding of institutional developments relevant to global financial stability. The term "macro" in the group's name indicates another element of the group's mandate, namely to explore the possibility that aggregating financial firms' stress test results might produce information that is of use to central banks, other financial regulators, and private-sector practitioners.

Members of the group interviewed risk managers at more than twenty large, internationally active financial institutions, both in their home countries and as a group at a meeting hosted by the Banque de France. From these interviews, the group gained a substantial base of knowledge on the current "state of the art" in the design and implementation of stress tests and on the role of stress testing in risk management decisions at the corporate level.

Drawing on this knowledge, the group then considered some of the issues relating to the aggregation of the results of stress tests conducted at different financial firms. The group concluded that, under ideal circumstances, aggregate stress tests could potentially provide useful information in a number of areas. Aggregate stress tests might be used by financial firms to help make ex ante assessments of market liquidity risk under stress when evaluating the riskiness of a trading strategy. Central banks and financial regulators might use them to more effectively monitor broad patterns of risk-taking and risk-intermediation in financial markets. However, the group also noted that it is as yet unclear whether such ideal circumstances prevail. In particular, it is unclear whether an appropriate reporting population can be assembled, whether the stress tests currently conducted by financial firms are compatible with one another, and whether the information obtained would justify the reporting burden.

The report concludes that stress testing is likely to remain an important element of the risk management strategies of large financial firms, and that further information about stress testing practices could prove informative regarding the vulnerabilities faced by the financial system. Accordingly, the report recommends that a one-off survey of the scenarios currently used by risk managers be conducted.

The report is organised as follows. The first chapter summarises current practices in stress testing and discusses some of its limitations. Chapter 2 of the report examines the potential usefulness of aggregate stress tests, discusses the methodologies that could be used to construct aggregate stress tests and gives a preliminary discussion of the trade-offs that would be involved in an aggregate stress testing program. Chapter 3 presents and discusses the proposed census of scenarios. There are three annexes to the report: a bibliography, a conceptual discussion of what aggregate stress tests might tell us about market liquidity risk, and a discussion of the issues raised by the dynamic aspects of market behaviour under stress.