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CEBS Guidelines on Stress Testing Consultation Paper Summary

Core Content

The Consultation Paper "CEBS Guidelines on Stress Testing" (CP 32), published by the Committee of European Banking Supervisors on 14 December 2009, outlines principles and recommendations for integrating stress testing into risk governance and management. The paper emphasizes the importance of stress testing in identifying weaknesses and improving capital and liquidity planning. However, the document also contains several criticisms and recommendations for refinement.

Main Views and Key Points

General Observations

• Principles-oriented approach: The paper is seen as a good start, but the recommendations should be derived from the experience of stress testing efficiency.
• Avoid overemphasis on financial crisis: A strong focus on the financial crisis should be avoided to prevent narrowing the scope of stress testing.
• Proportionality principle: Stress testing should be proportional to the size, risk profile, and risk types of the institution. Smaller institutions should be allowed simplified methods like sensitivity analysis.
• IT systems and costs: The requirement for bank-wide stress scenarios and flexible platforms leads to high IT costs and complexity. These should be reconsidered.
• Clarification needed: The paper lacks clarity on the relationship between traditional risk measurement and stress testing, as well as the meaning of "proportionality" and the concept of "narrative scenario".
• Implementation timeline: The proposed deadline for implementation is considered too short, especially regarding IT conversion, and should be postponed to the end of 2010.

Governance Aspects

• Management involvement: The involvement of the management body in stress testing should be inversely proportional to the size of the institution. For large institutions, the role of the management body should be limited to key decisions, while detailed design should be handled by committees or the CRO.
• Capital buffer based on stress tests: It is not appropriate to use stress test results to determine mandatory capital buffers, as this may create incentives for less rigorous testing.
• Contingency plans: Contingency plans should not be mandatory for all risk types, and their implementation should not be seen as a required action.

Methodologies

• Sensitivity analysis: Should be used for basic stress testing, with a focus on deeper analysis and interpretation rather than increasing the number of tests.
• Scenario analysis: Should be limited to cases where there is a clear benefit in risk management. They are complex and costly, so they should be treated as examples.
• Reverse stress testing: Is considered impractical and should be deleted due to high costs and limited additional insights.
• Concentration risk: Inter-risk-type concentration measurement is not feasible and should be deleted. Internal capital models already account for concentration risks within individual risk types.

Portfolio and Firm-wide Stress Testing

• Firm-wide stress testing: The term "firm-wide" is ambiguous and should be clarified. It should not imply a uniform approach for all entities in a group.
• Expected loss as output: The focus on expected loss as an essential output is questioned. It should be clarified whether it is a reference value or a core output.
• Capital planning stress tests: These should not be automatically linked to capital buffers. Institutions should decide based on their internal procedures and risk management needs.

Supervisory Review

• Regular reviews: Should be conducted at most annually and outside official examinations to encourage open dialogue.
• Capital and liquidity buffers: Supervisors should not set standards based on their own models. These should remain a bank-driven process.
• Data confidentiality: Stress test results should be disclosed only in the core college, not the general one, to protect sensitive information.

Annexes and Specific Areas

Annex 2 – Securitisation

• Stress tests for securitisation should consider relevant information but not necessarily require loan-by-loan data. Top-down parameters are acceptable, especially for homogeneous portfolios.

Annex 3 – Credit Risk and Counterparty Risk

• Stress testing should not be based solely on external events, as the causal link is not universally valid.
• Stress tests should consider material changes within the institution, such as new products and systems, and should not be tied to AMA components in non-AMA institutions.
• The requirement to stress BEICF (Business Environment and Internal Control Factors) is questioned due to lack of causal link with macroeconomic factors and should be deleted.

Annex 4 – Operational Risk

• Stress tests should not be directly linked to macroeconomic factors, and the requirement for scenario analyses on all four AMA elements is problematic.
• The paper lacks concrete examples and specific stress assumptions, making the requirements impractical.

Annex 5 – Liquidity Risk

• The full loss of funding facilities is considered too conservative and not risk-based. Business model and credit standing should be considered.
• Additional liquidity indicators derived from stress tests are not necessary, as most already include stress assumptions.

Annex 6 – Interest Rate Risk in the Banking Book

• The link between stress testing requirements and Basel interest risk coefficients should be clarified.

Conclusion

The consultation paper provides a framework for stress testing but faces significant criticism regarding practicality, proportionality, and the potential for creating unintended incentives. The recommendations should be more flexible, avoid excessive reliance on IT infrastructure, and ensure that stress testing complements, rather than replaces, traditional risk measurement procedures.