Stress Testing for Risk Control Under Basel II (eBook)

Front Cover 1
Stress Testing for Risk Control under Basel II 4
Copyright Page 5
Table of Contents 6
Preface 12
Warning 16
Part 1 Stress testing defined 26
Chapter 1 The need for advanced testing methodology 28
1.1 Introduction 28
1.2 Risk distributions and extreme events 28
1.3 Model uncertainty in simulation and testing 31
1.4 Stress testing and the need for transparency 33
1.5 Stress testing and confidence intervals 36
1.6 Advanced testing methodology for better governance 40
1.7 An introduction to the role of information technology in gaining competitiveness 42
Notes 45
Chapter 2 Risk and its management 46
2.1 Introduction 46
2.2 Risk defined 46
2.3 Risk associated with the counterparty 49
2.4 Market risk and its variants 52
2.5 Risk appetite and risk aversion 55
2.6 Systemic risk and event risk 59
2.7 Developing a system for risk management 61
Notes 64
Chapter 3 The dynamics of stress testing 65
3.1 Introduction 65
3.2 Stress testing defined 65
3.3 Advanced testing and new financial instruments 68
3.4 What is the benefit of stress testing? 70
3.5 Scenarios, sensitivity analysis and statistical inference 73
3.6 Capital at risk under extreme conditions: an example 75
3.7 Stress testing and the devil’s advocate 78
3.8 Advice on implementing the stress test 81
Notes 83
Chapter 4 Stress analysis and its tools 85
4.1 Introduction 85
4.2 The need for a scientific approach 85
4.3 Science and the scientific method 88
4.4 Fundamentals of stress analysis 91
4.5 Case studies with scenario analysis 94
4.6 Using the Delphi method 96
4.7 Stress evaluation through sensitivity analysis 99
4.8 Fundamentals of statistical inference 101
Notes 104
Chapter 5 Worst case scenarios and drills 105
5.1 Introduction 105
5.2 Worst cases happen when chance meets unpreparedness 105
5.3 A bird’s-eye view of worst case analysis 107
5.4 Impaired claims, credit risk and worst case 109
5.5 Why are worst case drills important? 111
5.6 A catastrophe drill undertaken by the International Monetary Fund in 2002 113
5.7 The Federal Reserve’s ‘new bank’ and the carry trade 115
5.8 The nature of worst case drills is polyvalent 117
Notes 120
Chapter 6 Technology strategy for advanced testing 122
6.1 Introduction 122
6.2 Managing a successful technology effort 122
6.3 Innovation and survival of the fittest 124
6.4 A phase-shift technology strategy 128
6.5 Re-engineering information technology is not an option it is a ‘must’
6.6 Projecting and implementing an enterprise architecture 134
6.7 Strategic planning should account for information technology’s deliverables 138
Notes 142
Part 2 Stress testing probability of default, loss given default and exposure at default 144
Chapter 7 Models and procedures for the study of volatility patterns 146
7.1 Introduction 146
7.2 Volatility defined 146
7.3 Keeping volatility in perspective 149
7.4 Improving volatility models through heteroschedasticity 153
7.5 Procedural insufficiency among financial institutions and individual investors 156
7.6 Algorithmic insufficiency: a case study with value at risk 157
7.7 The volatility of credit ratings: a case study with General Motors and General Motors Acceptance Corporation 161
7.8 Risk estimates based on volatile probability of default 165
Notes 168
Chapter 8 Stress testing creditworthiness 169
8.1 Introduction 169
8.2 Credit risk defined 169
8.3 Credit standards and default likelihood 172
8.4 The discriminatory ability of power curves 175
8.5 The predictive power of distance to default 178
8.6 The risk of unwillingness to perform 180
8.7 Case study: the stakeholders of TeleDenmark 183
8.8 A lesson for stress testers: loss of creditworthiness has many fathers 186
Notes 188
Chapter 9 Stress probability of default 190
9.1 Introduction 190
9.2 Probability of default and liquidity stress testing 190
9.3 Concentrations of exposure and credit risk measurement 194
9.4 Probability of default and stress probability of default 197
9.5 Estimating probability of default through probability of default buckets 200
9.6 Errors in probability of default estimates and the role of benchmarking 203
9.7 The many aspects of confidence placed on a test 206
Notes 208
Chapter 10 Stress loss given default and stress exposure at default 210
10.1 Introduction 210
10.2 Loss given default and exposure at default 210
10.3 The challenge of computing stress loss given default 212
10.4 Stress loss given default and ability to perform 215
10.5 Stress exposure at default 218
10.6 Point-in-time and through-the-cycle probability of default 221
10.7 Stress testing legal risk 223
10.8 Stress testing other operational risks 226
Notes 228
Chapter 11 Counterparty credit risk, transfer of credit risk and wrong-way risk 229
11.1 Introduction 229
11.2 Counterparty credit risk 229
11.3 Methods for handling counterparty credit risk 231
11.4 Expected positive exposure and cross-product netting 233
11.5 Maturity parameters 236
11.6 Credit risk mitigation: collateral and haircuts 237
11.7 Credit risk mitigation: new techniques 241
11.8 Double default: general and specific wrong-way risk 243
Notes 246
Part 3 Expected and unexpected losses 248
Chapter 12 Stress testing expected losses 250
12.1 Introduction 250
12.2 Bird’s-eye view of expected and unexpected losses 250
12.3 Stress testing regulatory capital requirements for expected losses 253
12.4 Back to basics: do we know the reason for credit losses? 256
12.5 Contribution of rating agencies to prognostication of expected losses 258
12.6 How to handle expected losses from lending 261
12.7 The results of the fifth Quantitative Impact Study 264
12.8 Thinking about models for credit risk 266
12.9 Strengths and weaknesses of credit risk models 268
Notes 272
Chapter 13 Analysing the reasons for unexpected losses 273
13.1 Introduction 273
13.2 Unexpected risks confront every enterprise 273
13.3 Impact of macroeconomic developments 276
13.4 Risk drivers targeted by macro stress tests 279
13.5 Stress testing macroeconomic risks and opportunities 281
13.6 Stress testing financial instruments: a case study with interest rates 283
13.7 Stress testing for unexpected losses from business risk 287
Notes 291
Chapter 14 Economic capital and algorithms for stress testing unexpected losses 292
14.1 Introduction 292
14.2 Economic capital for credit rating and unexpected losses 292
14.3 Capital beyond loan-loss provisions 295
14.4 Wrong correlations magnify unexpected losses 299
14.5 The missing algorithm for unexpected losses 301
14.6 Qualitative scenario for unexpected losses 305
14.7 The board needs tools to appreciate the value of assets 307
Notes 310
Chapter 15 Stress testing leveraged and volatile financial assets 311
15.1 Introduction 311
15.2 Hedge funds: an industry born in the 1940s 311
15.3 Stress testing highly leveraged institutions 313
15.4 The proliferation of hedge funds and testing their risks 315
15.5 The exposure of credit institutions to highly leveraged institutions 317
15.6 Supervision of highly leveraged institutions 320
15.7 Highly leveraged institutions at the peak of their might: No! to regulation 322
15.8 The drama unfolds: highly leveraged institutions fire the boss of the Securities and Exchange Commission 325
Notes 327
Chapter 16 Advanced testing provides a basis for better governance 328
16.1 Introduction 328
16.2 A concept for better corporate governance 328
16.3 The contribution of strategic thinking 330
16.4 Use of threat curves and S-curves: an example from the insurance industry 332
16.5 An oil industry case study on risk factors and their background 335
16.6 Pillar 2 and Pillar 3 require an enterprise-wide risk discipline 339
16.7 The exercise of market discipline is a significant step in supervision 341
16.8 Use of stress testing by central banks and regulators, for better governance reasons 343
Notes 346
Index 347