The importance of continuing to enhance your organization's Stress - - PowerPoint PPT Presentation

R Kula Moodys confer Final 10 5 11 1

The importance of continuing to enhance your

• rganization's Stress Testing program

Robert G. Kula, EVP KeyCorp

October 5, 2011

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• The views expressed here are my own, and not

necessarily those of KeyCorp.

• I helped draft Key’s Presentation and Publishing

Disclosure Guidelines.

Disclaimer

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Background

KeyCorp:

• Has assets of approximately $90 billion.
• Is headquartered in Cleveland, Ohio.
• Provides a wide range of retail and commercial

banking, commercial leasing, investment management, consumer finance, and investment banking products and services to individual, corporate and institutional clients.

• Has 1,040 full service retail banking branches in 14

states, and 1,547 ATMs.

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My Group is part of Risk Management

Quantitative Risk Analysis (QRA) is focused on:

• Economic Capital Attribution and Reporting.
• Commercial Risk Rating models.
• Stress Testing.
• Model Risk Control.

A number of Moody’s tools are leveraged in the bank:

• RiskCalc, RiskFrontier, RiskAnalyst, Economy.com, etc.
• And we are a participant in the credit research database.

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The connection between Stress Testing, ERM, and Economic Capital – and some high level “wisdom”

• Economic Capital attribution was ERM before ERM.
• Economic Capital attribution was stress testing before stress

testing.

• All implausible stress testing scenarios are somewhat

plausible.

• No matter how severe the stress is that you define, an even

more extreme stress can be developed.

• You need to document everything you do and everything you

think about. (As well as everything you didn’t think about.)

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“wisdom” continued

• Bad times are a function of good times, i.e., bad = f(good).

The trick is knowing when this will happen. What are the early warning signs?

• Some loans that were good for a real long time will default

during bad times.

• Unfortunately, despite everything being done in the industry
• ver the last two years (risk appetites, risk tolerances, stress

testing, etc.), future downturns cannot be prevented.

• When in doubt, you can always blame the model or modeler.
• Despite what anyone says, no risk rating model is entirely

“through-the-cycle” or purely “point-in-time.” All are a mix

• f the two.

R Kula Moodys confer Final 10 5 11 7 Probability of Loss 0% Loss Rate 100%

Zero Losses Expected Loss Potential “Unexpected” Losses for Which Capital Should be Held Potential “Unexpected” Losses Against Which It Would be too Expensive to Hold Capital

Capital Reserves Reserves

Economic Capital and Stress Testing go hand in hand.

Base | X Stress #1 | X Stress #2 | X

Economic Capital attribution is a form of stress testing – looking out over the next year.

Equates to Confidence Level

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Learnings around Stress Testing

• Expanded Stress Testing activities are good for the business

(i.e., good risk management), and a necessary component of an Internal Capital Adequacy Process (ICAP).

• Coordinated bank-wide stress tests need to have a consistent

starting point (or kickoff) – the agreed upon scenario (e.g., the forecasted macro economic indicators).

• Stress Testing is a repeatable process, not a one-time project –

there needs to be a dedicated team with clear roles & responsibilities (cutting across Treasury/Finance, Risk Management, the LOBs, etc).

• Stress Testing needs to connect directly into Capital Planning,

Profit Planning, and Strategic Planning.

• There needs to be a focus on continuous improvement…

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• Risk Rating models – mapping macro economic variables to

the drivers of capital for each risk (e.g., in the case of Credit Risk, the drivers are PD and LGD).

• Historical transition matrices.
• Economic Capital models (run at various confidence levels).

And the more granular the better (i.e., segmenting by product, industry, geography, etc.).

…For example, for Credit Risk, there are a number

• f models/methodologies that can be leveraged:

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Macro Scenario – Variables

• GDP.
• Unemployment.
• Home Prices.
• Credit spreads.
• Consumer Price Index.

Risks

• Credit, Market, Operational, Liquidity, etc.

…But remember that Stress Scenarios are developed to be applied across all risk types.

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Learnings around Stress Testing (cont’d)

• You need to continually strive for the right balance of

quantitative analysis (e.g., modeling) and qualitative analysis (e.g., expert/fundamental credit analysis).

• A risk management culture is enhanced with the development
• f a well-defined risk appetite and a set of risk tolerances.

This brings even more meaning to activities such as stress testing (e.g., how far out of tolerance will my stress take me?).

• Strong governance (e.g., an ERM Committee & the Board) is

essential.

• Third party perspectives and benchmarking can help enhance

the overall process.

• You should be thinking about stress testing all the time…

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…and connecting your Stress Testing scenarios to the real world.

• Something (e.g., Greece, price of oil, Egypt, Japan, etc.)

actually causes the stress scenario – and this is reflected as a worsening GDP, higher unemployment, etc.

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Making a list of Macro risks is easy. Translating each risk to an actionable scenario is more difficult.

Financial System

• Lack of product demand
• Failure to execute (creating credit risk, market risk,

and operational risk)

• Unintended consequences of regulation
• Responses to the pressures to grow

U.S. Economy

• Poor leadership
• Lack of Confidence/Fear
• Lack of agreement on methodologies to avoid a

prolonged slump

• Drag from Europe

World

• Global warming
• Oil
• Weather events
• Nuclear event(s)
• Pandemic

(And sometimes it’s hard to differentiate the causes from the effects.)

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• Maintaining deep historical data, with good data quality.
• Drilling down to the “right” level of granularity of the models.
• Having well-defined Stress Testing documentation, which

revolves around the:

– Data used. – Assumptions made. – Models chosen. – Calculations. – Scenario(s) defined (e.g., economic conditions).

• Understanding inter-risk correlations (is there diversification
• r a magnification effect?).
• Strong Model Governance.

Common challenges in the industry in developing enterprise-wide stress tests

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With more and more models being developed and utilized for Stress Testing:

• Model risk control and model governance becomes even

more essential.

– Model Risk is a material risk. – Promoting good model building helps reduce model risk.

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• Proposed Guidance on Stress Testing.
• Section 165(i) of the Dodd-Frank Act.
• Reverse stress testing, living wills, etc.

What can you do???

• Closely follow all regulatory and industry developments, and

participate in industry trade groups to review and comment on proposed rules as they are published.

• Stay closely engaged with bank regulators – what are best

practices? And what are the range of practices?

Things are still being defined and there are many things to think about

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Many Choices for Next License Plate

• SCAP19 ??? CCAR??? CCAR II??? SIFI??? ICAP???