Understanding Risk Management and Compliance, What is different after Monday, October 21, 2013 [NOOK Book]

Overview

Do you use "a suite of models" as part of your stress-testing framework?

"It is reasonable to assume that any single model will almost certainly be wrong."

The Bank of England says so. They will do the same:

"The Bank expects to use a suite of models to do this, rather than rely on a single model.

Why a suite of models?

There are a number of...

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Understanding Risk Management and Compliance, What is different after Monday, October 21, 2013

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Overview

Do you use "a suite of models" as part of your stress-testing framework?

"It is reasonable to assume that any single model will almost certainly be wrong."

The Bank of England says so. They will do the same:

"The Bank expects to use a suite of models to do this, rather than rely on a single model.

Why a suite of models?

There are a number of benefits in using a suite of models as part of the stress-testing framework.

First, the banking system faces many different types of risk, including market, credit, funding and liquidity risks.

Although these are often interrelated, it is not realistic to expect that a single model will capture the entirety of these risks effectively.

Moreover, reliance on a single quantitative tool heavily exposes the stress-testing exercise to 'model risk'.

All models are a simplification of reality, so it is reasonable to assume that any single model will almost certainly be wrong.

Having recourse to a suite helps reduce the sensitivity of the results to a particular model's 'blind spot' or miscalibration.

Different models also give different insights and perspectives to policymakers, serving as a useful cross-check to each other.

Indeed, the range of outputs from different models can itself be informative, providing useful insights to policymakers on uncertainties around banks' capital positions in a given scenario.

Using a suite of models also reduces the risk that individual banks might seek to 'game' the stress-testing framework by seeking to restructure their balance sheets in a way that reduces measured risk under a particular model.

Finally, from a system-wide perspective, relying on a single model could have adverse consequences for diversity in risk measurement and risk management practices across the system.

Using a suite of models is not without costs, however. It will add some degree of complexity to the overall exercise."

Interesting...

I loved the "It will add some degree of complexity" part.

I would add that it will increase the cost of compliance too. If we want to have more Common Equity Tier 1 (CET1) capital, we need profits and investors. Everything that increases the cost makes me nervous.

The new paper from the Bank of England is one of the best that covers the financial stress testing cycle:
"We have a great example of the key stages of the annual stress-testing cycle.

The UK Financial Policy Committee (FPC) recommended in March 2013 that, 'looking to 2014 and beyond, the Bank and Prudential Regulation Authority (PRA) should develop proposals for regular stress testing of the UK banking system.

(1) Design common scenarios (approximately twelve weeks).

The FPC (Financial Policy Committee, established under the Bank of England Act 1998, through amendments made in the Financial Services Act 2012) liaising with the PRA Board, will design the common scenarios for the forthcoming round.

The scenarios will then be released to banks. It is expected that the data cut-off will be at approximately the same time as this release.

(2) Banks' scenario design (approximately twelve weeks).

In order to run the common scenarios using their own models, banks are likely to have to extend the number of variables provided by the Bank.
Individual banks will also likely be required to design their own, bespoke, scenarios.

Banks would be expected to do much of this work — for example, identifying the risks that the bespoke scenarios will articulate — in parallel with the design of the common scenarios by the FPC.

Given the expectation that the bank-specific scenarios should be more severe than the common scenarios, banks will have a further month to calibrate their own scenarios after they receive the common scenarios.

Banks will be required to submit the bespoke scenarios for review to the PRA.

(3) Independent stress-testing analysis (approximately twelve weeks).

Staff at the Bank as well as individual banks themselves will conduct the stress-testing

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