Learning Objectives: Describe the evolution of the stress testing process and compare methodologies of historical EBA, CCAR, and SCAP stress tests. Explain challenges in designing stress test scenarios, including the problem of coherence in modeling risk factors. Explain challenges in modeling a bank’s revenues, losses, and its balance sheet over a stress test horizon period.
Questions:
24.14.1. At a risk committee meeting, your colleague presented the evolution of stress testing methodologies since the implementation of the Supervisory Capital Assessment Program (SCAP). His opening remarks included the following statements:
a. Statement 1
b. Statement 2
c. None of them
d. Both of them.
24.14.2. Given the complexity of managing portfolios that are marked to market within a value-at-risk (VaR) system, a risk management team at a global investment bank is tasked with designing a new market risk stress testing scenario. The scenario must account for coherence among tens of thousands of risk factors mapped from hundreds of thousands of positions.
Which approach should they prioritize to manage the coherence challenge effectively while ensuring the scenario's practicality?
a. Base the scenario solely on historical market data from the most recent financial crisis to ensure that all risk factors reflect past realized correlations.
b. Design a targeted scenario that focuses primarily on the most volatile risk factors, using recent market data to project future interactions and dependencies.
c. Develop a model that utilizes advanced statistical techniques to estimate volatilities and correlations among risk factors, simulating potential market responses under stress conditions.
d. Construct a scenario that articulates the risk landscape by focusing on economic indicators like GDP growth, unemployment, and house price index, similar to the approach used in SCAP.
24.14.3. Three analysts at Largo Bank have been tasked with developing a stress test model to ensure capital adequacy over a two-year horizon.
a. All three are correct.
b. John is correct.
c. Only Greta is correct.
d. Both Greta and Dace are correct.
Answers here:
Questions:
24.14.1. At a risk committee meeting, your colleague presented the evolution of stress testing methodologies since the implementation of the Supervisory Capital Assessment Program (SCAP). His opening remarks included the following statements:
- Statement 1: Initially, the focus was mainly on potential losses within specific business units; now, the analysis includes broader financial impacts, such as revenues, operational costs, and the effects of various risk factors across the entire bank.
- Statement 2: Originally, stress tests did not consistently link results to specific capital ratios; now, tests evaluate outcomes against a variety of capital ratios, including common equity Tier 1 capital ratios, but they do not adequately assess the impact of operational risk.
a. Statement 1
b. Statement 2
c. None of them
d. Both of them.
24.14.2. Given the complexity of managing portfolios that are marked to market within a value-at-risk (VaR) system, a risk management team at a global investment bank is tasked with designing a new market risk stress testing scenario. The scenario must account for coherence among tens of thousands of risk factors mapped from hundreds of thousands of positions.
Which approach should they prioritize to manage the coherence challenge effectively while ensuring the scenario's practicality?
a. Base the scenario solely on historical market data from the most recent financial crisis to ensure that all risk factors reflect past realized correlations.
b. Design a targeted scenario that focuses primarily on the most volatile risk factors, using recent market data to project future interactions and dependencies.
c. Develop a model that utilizes advanced statistical techniques to estimate volatilities and correlations among risk factors, simulating potential market responses under stress conditions.
d. Construct a scenario that articulates the risk landscape by focusing on economic indicators like GDP growth, unemployment, and house price index, similar to the approach used in SCAP.
24.14.3. Three analysts at Largo Bank have been tasked with developing a stress test model to ensure capital adequacy over a two-year horizon.
- John's Perspective: He emphasizes that the model should use dynamic balance sheet assumptions. A dynamic approach adjusts for changes in risk-weighted assets (RWA) based on the evolving financial situation during the stress period.
- Greta's Perspective: She explains that the denominator of capital adequacy ratios is typically risk-weighted assets (RWA), which are crucial for determining whether the bank needs to raise capital. The modeling should accurately compute RWA based on the regulatory capital regime in place (e.g., Basel II).
- Dace's Perspective: He adds that capital actions, such as share repurchases, dividend changes, or issuance programs, should be accounted for in the stress test. These actions can deplete or conserve capital, directly impacting the bank’s capital adequacy.
a. All three are correct.
b. John is correct.
c. Only Greta is correct.
d. Both Greta and Dace are correct.
Answers here:
