Financial Risk Manager Part 1
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A newly appointed banking supervisor at a financial regulatory agency is tasked with reviewing a bank's stress testing procedures. The goal is to ensure these procedures conform to the best practices as stipulated by the Basel Committee on Banking Supervision guidelines for stress testing. What suggestions would the supervisor make to ensure the bank's stress testing aligns with these recommended best practices?
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A
The bank's management team should fully delegate critical stress testing responsibilities, such as setting objectives and defining scenarios, to experts in the risk management area.
B
The bank's business units should individually estimate the impacts of stress scenarios without considering interactions between their unit and others, to accurately estimate the true risk of each unit.
C
The bank should include scenarios in its stress tests featuring potential shocks to the bank's portfolio that have not occurred in the past.
D
The bank should not consider system-wide liquidity in its stress testing, as this issue is outside the intended scope of these tests
Explanation:
C is correct. Prior to the 2007-2008 crisis, an overreliance on historical scenarios caused stress tests to be too mild and have durations that were too short. This also contributed to insufficient consideration of the risks created by introduction of new products and the new positions taken by banks. A is incorrect. The involvement of the board and senior management is important; they should be involved in setting stress-testing objectives, defining scenarios, discussing the results of stress tests, assessing potential actions, and decision-making. B is incorrect. Stress tests should consider interactions between business lines so that banks can aggregate exposures and develop an enterprise-wide risk view. A number of institutions failed in this regard during the 2007-2008 crisis. D is incorrect. A failure of stress testing prior to the 2007-2008 crisis was that the impact of stressed scenarios on liquidity was underestimated. The systemic risks stemming from banks' hoarding of liquidity were unforeseen.
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