casemark/conducting-stress-testing

Conducting Stress Testing

When To Use

• Designing scenario-based stress tests for portfolios, business lines, or enterprise-wide exposures
• Running regulatory stress tests (CCAR, DFAST, EBA/ECB exercises) or internal capital adequacy assessments
• Evaluating portfolio resilience to hypothetical or historical shock events
• Analyzing concentration risk, liquidity gaps, or tail-risk exposures under adverse conditions
• Preparing board-level or regulatory stress test reports with P&L impact and capital impact estimates

Inputs To Gather

• Portfolio data: Current positions, asset classes, notional values, maturities, counterparty exposures, and hedges
• Scenario specifications: Macro variables to shock (GDP, unemployment, interest rates, credit spreads, FX, equity indices, commodity prices) with severity levels and time horizons
• Historical reference events: Specific episodes to replicate (e.g., 2008 GFC, COVID-19 March 2020, 2022 rate hiking cycle, SVB contagion)
• Risk factor mappings: How portfolio holdings map to stressed risk factors (betas, sensitivities, duration, convexity, Greeks)
• Model assumptions: Correlation behavior under stress, recovery rates, prepayment speeds, liquidity haircuts
• Regulatory parameters: Prescribed scenario variables and reporting templates if running a supervisory exercise [VERIFY: confirm applicable regulatory framework — Fed SR 12-7, EBA Guidelines, PRA SS3/21, or local equivalent]
• Thresholds and limits: Capital ratios, risk appetite limits, and early-warning triggers to evaluate against results

Workflow

1. Define scope and scenario design

   • Classify test type: sensitivity (single-factor), scenario (multi-factor), reverse stress test, or enterprise-wide
   • For historical scenarios, source actual market moves for the reference period and calibrate shocks to current portfolio composition
   • For hypothetical scenarios, specify narrative (e.g., "stagflation with sovereign contagion"), translate to quantified risk factor shocks, and document the transmission channels
   • Set time horizon (instantaneous shock, 1-quarter, 9-quarter CCAR window) and granularity (daily, monthly, quarterly)

2. Map exposures to risk factors

   • Link each position or sub-portfolio to the stressed variables using factor sensitivities, regression betas, or full revaluation models
   • Identify second-order effects: margin calls, collateral shortfalls, funding cost increases, behavioral responses (deposit flight, drawdowns on credit lines)
   • Flag any positions with no clear risk factor mapping — mark with [VERIFY] and document proxy assumptions

3. Execute stress calculations

   • Apply shocks to compute stressed P&L at position, desk, business-line, and consolidated levels
   • Calculate stressed capital ratios (CET1, Tier 1, Total Capital) incorporating pre-provision net revenue (PPNR) projections under the scenario
   • Run liquidity stress: project cash inflows/outflows under the scenario, compute survival horizon, and test against LCR/NSFR minimums [VERIFY: applicable liquidity metrics for jurisdiction]
   • For reverse stress tests, solve backwards from a failure threshold (e.g., CET1 < 4.5%) to determine the scenario severity required

4. Analyze and interpret results

   • Rank loss contributors by magnitude — identify the top 5-10 drivers of stressed losses
   • Compare results across scenarios to isolate which risk factors matter most
   • Assess whether losses breach risk appetite limits, regulatory minimums, or internal early-warning triggers
   • Evaluate hedging effectiveness under stress: do hedges perform as expected or do correlation breakdowns erode protection?
   • Identify concentration risks that only become visible under stress conditions

5. Document and report

   • Produce an executive summary: scenario narrative, aggregate loss estimate, capital impact, key vulnerabilities
   • Include granular breakdowns by asset class, geography, counterparty, and business line
   • Present sensitivity analysis around key assumptions (e.g., +/-50bps on recovery rate, alternative correlation assumptions)
   • State all model limitations, data gaps, and proxy assumptions explicitly
   • Recommend management actions: position reductions, hedge adjustments, contingent capital planning, limit recalibrations

Output

• Stress test results report containing: scenario descriptions, aggregate and segmented P&L impacts, capital ratio trajectories, liquidity projections, and breach analysis against limits
• Heat map or dashboard view ranking portfolios/business lines by vulnerability severity
• Management action recommendations with estimated risk reduction impact
• Assumption and limitation disclosures with [VERIFY] flags on jurisdiction-dependent parameters
• Appendix with detailed methodology, risk factor shock tables, and model validation notes

Quality Checks

• Confirm all portfolio positions are captured — reconcile total notional/market value against source systems before and after stress
• Validate shock magnitudes against historical precedent (stressed moves should not be implausibly mild or extreme without justification)
• Check arithmetic consistency: sum of position-level losses should equal portfolio-level loss (absent diversification/correlation adjustments, which must be disclosed)
• Verify capital ratio calculations use correct RWA methodology and starting capital figures [VERIFY: confirm RWA approach — standardized vs. IRB/IMA]
• Ensure scenario narratives are internally consistent (e.g., a deflationary scenario should not assume rising commodity prices without explanation)
• Confirm results are presented in consistent units (same base currency, same reporting date, same accounting treatment)
• Review that all [VERIFY] items have been resolved or escalated before final submission