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Risk -V- Reward – Is credit stress testing stressing you out?

8 August 2019

Stress is naturally considered as a negative.  Stressful job, stressful day, stressed out…. you know the list.  Whatever its cause, we always want to eliminate stress and move on.  How often do we give ourselves the chance to understand stress and to learn from it?  

High-performance athletes uniformly take a pro-active approach to dealing with stress.  They prepare in advance for adversity both physically and mentally in order to maximize performance and to reduce the risk of failure.  For athletes, stress testing is a critical part of their winning strategy.  Sport has long-standing associations with business – not just through marketing and sponsorship but also ideologically.  Yet, when it comes to preparing for high-performance, how often do financial institutions consider stress the way athletes do?

 load can your loan book bear?
What load can your loan book bear?

Risk and reward do not always have to be polarized

Stress testing is a practical risk management tool that can inform the senior management level, enabling the setting of realistic goals for lending policy and capital allocation while putting a contingency in place for adverse scenarios.  As in the case of the athlete, the benefits can extend beyond the immediate short-term goal of winning a game or successfully passing regulatory/compliance reviews. 

“Compared to pre-financial crisis spending levels, Financial Institutions spend on compliance has increased by over 60% for retail and corporate banks”

Deloitte

Stress testing isn’t just about “top down” regulatory compliance at the organizational level.  Accurately identifying and scoping risk profiles within the loan portfolio can only help an organization.  A thorough “bottom up” evaluation of the portfolio, fully prepares the bank for worst-case scenarios while enabling the validation of current lending limits and policies.  Ongoing credit stress testing (whether at the level of loan, account, security, group of securities or book) delivers the deep insights needed to drive better business decisions and customer relationship success. 

Dynamic stress testing as a business tool

In the case of wealth lending, and Securities-Based Lending (SBL) in particular, the environment can change very quickly.  Accurate and granular credit stress testing is critical in minimizing and managing credit risk.  More than that, wealth managers (WMs) are seeking to leverage stress testing results to drive efficiencies and opportunity.  Intelligent credit stress testing of the SBL book emerges as a critical business tool – whether to help better control of concentration risk across the book, or to flexibly manage credit policy at a loan level in order to improve the customer experience.

WMs are evolving to respond dynamically to stress testing insights.  Detailed sensitivity analysis enables better credit risk management in the loan book.  Even within a business line, credit policies can flex as on-boarded collateral affects loan concentration.  Understanding those aspects of the portfolio that are vulnerable to sudden market shifts or sectoral swings can influence the direction of credit policy and help managers to make dynamic decisions on portfolio composition – or at least to understand the broader capital- and risk- impact of their loan decisions.

FASTNET - Stress testing dashboard
Stress testing dashboard – FASTNET

Tough lending decisions are supported by this deeper knowledge of the components of the loan book and the relative contribution of one collateral asset class over another.  For example, a loan application supported by a portfolio of securities that are not heavily represented in the loan book will diversify the book and potentially offset some concentration risk.  Knowing that a borrower’s portfolio of securities will reduce rather than increase concentration risk in the loan book may result in a more favorable credit decision on a loan that, at face value, might have been treated negatively.  Likewise, being able to price loans in a way that reflects the impact of the loan on portfolio composition level makes good business sense.

Stress testing data  - FASTNET
Stress testing data – FASTNET

React quickly for risk mitigation and customer success

In the case of SBL, when markets move quickly WMs need to respond quickly.  Severe market volatility or sudden large price moves in a popular stock can trigger a deluge of out-of-margin and top-up events.  Knowing what to tackle first and how to de-risk the book quickly is mission-critical.  WMs need to have a strong grasp on:

  • Exactly how the SBL book is exposed to any specific security. Is there a risk of secondary effects if we have to close out any substantial holding(s)?
  • What is the impact of futures pricing on my SBL book today?  
  • If futures price weakness is applied to my portfolio, how many loans go out-of-margin?
  • If current market volatility/trends continue for a day, or number of days, how many out-of-margin calls can I expect? What demands will this place on operations resourcing?

WMs also want to be able give their clients loan-level visibility on market sensitivity, e.g. if the market continues to move at current levels, when can I expect a margin call?. This enables the client to be better-prepared for potential margin calls and to decide what action to take to avoid sudden moves. 

Credit stress testing for SBL continues to evolve – encompassing factors like market liquidity – whereby highly-traded securities may be treated more favorably, whether from a loan pricing or advance rate perspective. 

FASTNET, Rockall’s SaaS solution for SBL, offers flexible credit stress testing to help to identify risk indicators, set up contingency plans and refine the capital distribution of securities-based loans.  Based on accurate loan data and daily market prices and ratings, FASTNET simulates loan book behavior and enables testing for multiple “What If” scenarios to instantly uncover risk exposures in the SBL book.

FASTNET’s scenario simulator displays projected impacts on collateral accounts and associated loans, uncovering where the book is particularly exposed to certain securities, or groups of securities including asset classes or geographies.  Modeling of out-of-margin volumes and triaging strategies enables future-proofing of your wealth lending strategy.

Training helps the athlete prepare for the worst case scenario – and in doing so strengthens overall performance.  Likewise, having a detailed handle on credit stress testing and the impact of market reverses and concentration risk in the SBL book improves the strength of the WM business.  How well-equipped is your organization to undertake granular, business-driven SBL credit stress testing?

If you would like to learn more, please visit us at rockall.com

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