Since 2008, stress tests have become a critical element of risk management for banks and a core tool for banking supervisors and macroprudential authorities. So why aren’t they working?
Why, after years of low-interest rates, have interest rate rises exposed several banks’ risk positions, destabilizing banking shares across North America? Are stress tests and risk management practices no longer fit for purpose? Do banks have the right data and systems to devise the scenarios current circumstances demand? Do the imaginations of risk teams need re-ignition?
What is going wrong at some US banks?
An asset-liability mismatch initiated the crisis at Silicon Valley Bank (SVB), which precipitated the ongoing confidence problem in regional and specialized banks in North America.
A fundamental issue is holding back the risk management approach at many banks. In deciding stress test scenarios, banks often align their efforts with regulatory requirements or market best practices, which is not enough. Banks also need to look to internal business and risk analysis perspectives.
How appropriate are some banks’ stress test scenarios?
In February this year, the US Federal Reserve published its macroeconomic scenarios for the 2023 stress test of large banks. Ironically, in its “severely adverse” scenario forecast, there is a steep decline in interest rates, which return to low levels for the entire three years of the scenario.
Critically, every severely adverse scenario the Fed has used since 2015 has the three-month Treasury bill rate ending at 0.1 percent. So there’s a mismatch between this 2023 stress scenario and the steep increase in interest rates in the last few years.
Why?
It seems cheap credit and low-interest rates have warped our idea of risk. Over-exposed banks have failed to plan for rising rates because central banks and regulators view adverse scenarios differently. Consequently, risk teams need more imagination to foresee the worst-case scenarios of their portfolio positions.
The World Trade Center attacks, the COVID-19 pandemic, and a war in Ukraine would have been thought highly improbable – if not impossible. But prudent risk management requires risk teams to possess sufficient imagination to consider these possibilities and guard against them. The rise of interest rates wasn’t improbable; it was inevitable. Just repeating a broadly similar scenario year after year misses the opportunity to provide supervisors with potentially important information on vulnerabilities, and creates the misimpression for policymakers that banks are more resilient to different types of shock than they really are.
It has become very clear that the industry needs a more collaborative approach to understand the full landscape of potential risks, and results need to be reviewed and discussed in more detail between all parties.
Re-learning key lessons from 2008: how do banks prepare for the unexpected?
Internally, banking leaders must begin asking some fundamental questions:
- How effective is the supervisory approach in identifying risks?
- Do supervisors and analysts have the tools to identify and mitigate threats to the bank’s safety and robustness?
- Do senior executives have real-time actionable insight into the risk position of their banks against specific scenarios?
- Are risk managers given the mandate to think the unthinkable?
The timeline of SVB’s collapse suggests the senior team missed critical opportunities to course-correct. If a risk management team applied common-sense, realistic, worst-case scenarios, the bank’s risk position would have been highlighted as unsustainable.
So what lessons have we yet to learn since the 2008 financial crisis?
- Stress tests should consider severe but realistic scenarios, including low-probability events with potentially adverse effects
- Sound management information systems are critical to the ability of firms to manage risks
- Banks should allow for multiple inputs into the risk-assessment process. That means organizations must possess and use the best available data and information for their risk models.
The current assessment is that some banks may need to improve on one, if not all, of these critical lessons. The Fed’s Silicon Valley Bank (SVB) review shows that US financial authorities recognize that they must make bold moves to arrest the situation and get banks back on track.
In the case of SVB, the decisions of senior management should be a reminder to all banks to imagine the worst and assess the potential impacts of their decisions.
In 2023, the banking industry is plagued by an age-old problem – risk mismanagement. It is imperative that senior leadership teams learn key lessons from past crises by prioritizing their risk management capabilities and reimagining their stress testing scenarios or risk a contagion that leads to an even bigger global crisis.
