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Stress testing defn, 2 types (how to define changes)
- Risk mgt technique to evaluate potential effects of a set of specified changes in risk factors on financial condition from exceptional but plausible events
- Scenario testing (complex): uses hypothetical future state of world to define changes in a # of risk factors affecting operations, and involves
- ripple effects (other impacts that follow logically from these changes)
- related mgt and regulatory actions
- conducted over time horizon appropriate for business and risks tested
- Sensitivity testing (simple): incremental change in a risk factor (or a limited # of risk factors).
- conducted over shorter time horizon (instantaneous shock)
- requires fewer resources
- simpler technique for quick response or more frequent results
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Environment where stress testing is important
- Long periods of benign eco conditions leading to possible underpricicng
- During periods of expansion (when limited historical experience is available)
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Purposes of Stress Testing
- Risk id and control
- at detailed portfolio level and at institutional level.
- consider concentrations and interactions between risks
- Complement other risk mgt tools
- insights on validity of stat models
- assess robustness of models to changes
- simulate shocks not found in historical data
- assess impacts of customer behaviour
- Supporting capital mgt
- id severe events that would adversely affect the institution
- Improving liquidity mgt
- assess liquidity profile
- assess adequacy of liquidity buffers from stress events
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Responsibilities of Board and sr mgt - Stress Testing program
- Board:
- ultimately responsible for overall program
- Aware of key findings of stress tests
- Ensure sr mgt has a 'fit for purpose' program that is enterprise-wide
- Ensure policies in place to use stress testing as a risk mgt tool
- Sr mgt:
- implementation, mgt, oversight
- understand impact of stress events on risk profile
- review stress scenarios
- contribute to dev't of risk mitigation
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Considerations for Stress Testing Programs / ways to improve
- Consider views across org and wide range of expertise (to ensure comprehensiveness)
- Documentation of process and model assumptions
- Flexible infrastructure to allow for adjustments to be easily made and dynamic set of risks
- Constantly update the model
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Methodology and Scenario Selection - Stress Testing Programs
Should cover a range of: - risks and business areas
- scenarios and id interactions
- severities
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Specific Areas of Focus - Stress Testing Programs
- Risk Mitigation
- Securitization and Warehousing Risks
- Risks to Reputation
- Counterparty Credit risk
- Risk Concentrations: directly from risk taking activities and indirectly from risk mitigation actions. types:
- Single name
- regions or industries
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How does OSFI assess institutions’ stress testing programs
- Scenarios consistent with risk appetite?
- Frequency sufficient to support mgt action?
- Scenarios where viability is compromised
- Assess adequacy of capital buffers
- Review mgt actions
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