1. Regulatory Requirementsfor Stress Testing Barry Schachter Courant Institute, NYU (March 5, 2013)

2. Required Risk Measurement Stress Reverse Tests Stressed VaR Scenario Stress Tests Internal Standard Model (VaR) Model

3. Regulatory Stress TestingRequirements for Capital Adequacy Liquidity Threats to Viability Systemic Risk Disclosure Other Risk Management Purposes

4. Liquidity

5. Basel III Liquidity Stress Test Liquidity Coverage Ratio High quality liquid assets Cash outflows under stress (30 days)

6. Assets Liquid Under Stress Able to sell, borrow against with no loss even under severe market stress. Level 1: Cash, central bank reserves, securities backed by sovereigns and CBs In unlimited amounts Level 2: covered bonds, corporate debt, RMBS, some equities, some government securities In limited amounts with haircuts

7. Elements of Liquidity StressScenario Run on retail deposits Partial loss of wholesale funding Margin calls from 3 step credit downgrade Drawdowns of committed lending lines

8. Liquidity Stress Scenario Set out as minimum supervisory requirement LCR requirement must be satisfied continuously in normal times Banks must do additional scenarios Reflect business-specific activity Over longer time horizons Share results with supervisors Basel III: International framework for liquidity risk measurement, standards and monitoring (December 2010/January 2013) (bcbs188 and bcbs238)

9. Operational Considerations Assumptions size of run-offs and other impacts Data detailed collateral scenario forecasts Operational risks integrating systems to aggregate liquidity impacts Liquidity adjustments to pricing Consistency with liquidity assumptions in VaR

10. Capital Adequacy

11. Rules Apply to Who? Dodd-Frank (section 165): Financial HCos., Banks, S&Ls, SIFIs >$10 billion assets, SIFI >$50 billion CCAR: Bank HCos. >$ 50 billion assets >$100

12. What Tests? CCAR and D-F Dodd-Frank (Sect. 165) Annual supervisory stress tests for SIFIs, Banks>$50B in assets Annual company-run stress tests for Banks and Finc. HCos. >$10B Semi-annual company-run stress testing if >$50B in assets Company-run scenarios include a severely adverse scenario Minimum of three supervisory scenarios Mandated public disclosure CCAR Annual supervisory severe adverse stress test for large, complex bank HCos., >$100B in assets originally, now >$50B

13. Number of Affected Firmsas of Q3 2012 120100 Bank HoldCos > $100B 80 Fin HoldCos >$10B 60 *Fin HoldCos >$50B 40 Banks & S&Ls >$10B 20 SIFIs 0 Categories Source: FFIEC, FDIC, Federal Reserve

14. Whos In the 2012-2013 Cycle? CCAR 19

15. Whos In the 2012-2013 Cycle? CapPR 11 Other US BHCs >$50B in Assets

16. D-F/CCAR Stress Testing Cycle NovemberOctober 1 January 5 March15 15Fed & Banks Run Fed Runs Biggest PublicBanks Scenarios Own Reporting BanksDevelop Analyzes of ResultsScenarios Capital Mid- cycle Process

17. Stress Test Creation Shocks to 26 (for 2012-2013) macroeconomic variables, Translated into impact on items of income and expense, and Flow those imacts through quarterly net income Add to forecast changes in the capital account to estimate impact on regulatory capital Trading books subject to a separate, instantaneous shock

18. Macroeconomic Shocks2013 Supervisory Scenarios 2012-2013 DJ Total Stock Market 20000 18000 16000 14000 12000 11042.3 10000 8000 7221.7 6000 4000 2000 0

19. From macro shocks to gainsand losses Crucial! Two ways to go: implied relationship historical relationshipSee, e.g., CCAR 2012: Methodology and Results for Stress ScenarioProjections, Appendix A

20. Market Shocks SevereAdverse - Equity Equity by Geography 0% -15% New Zealand Switzerland United Kingdom Sweden Chile -30% Germany Mexico Philippines Turkey Australia Euro Stoxx 50 Malaysia India United States 600 South AfricaIndex FranceJapan Stoxx Europe Poland South Korea MSCIMSCI World China Hong Kong EAFE Belgium Finland Canada MSCI All Country -45% Denmark Hungary Taiwan Index Netherlands Czech RepublicBrazil Indonesia IsraelWorld Index Singapore Greece (ACWI) MSCI EM Index Italy Argentina Norway MSCI EMEA -60%Austria MSCI EM Latin Spain Index America Index -75% Bulgaria Russia Ireland Portugal Ukraine, -84.30% -90%

21. Supervisory Scenario Market Shocks to FX Vol

22. ATM USDMXN Vol History Supervisor Shock (vol pts)

23. Stress Testing under CCAR &D-F The details 9 quarter horizon, instantaneous shock for trading books As-of dates 9/30 (and 3/31) for annual (mid-cycle) tests Random end-Q4 as-of date for trading books Implementation decisions Interpolation, extrapolation, proxying shocks Bank baseline scenario adopt supervisory baseline? Models dont work with shocks Documentation Must use standard templates must document and justify deviations

24. Disclosure & SystemicRisk Assessment

25. Disclosure under D-F From banks to the supervisor FR Y-14M (and 14A and 14Q) From the supervisor to the public Details of shocks Using both D-F and bank capital plan assumptions Worst quarterly and end-of-horizon capital ratios for severe adverse scenario Using D-F capital plan assumptions Total 9 quarter net revenue and income, loan losses, trading and counterparty credit losses

26. Disclosure under D-F From Banks to the public types of risks included; description of company scenarios (key variables, such as GDP, unemployment rate, housing prices); description of the methodologies to estimate losses, revenues, and changes in capital; and net revenue and income, pro forma capital and capital ratios over the planning horizon.

27. Disclosure under Form PF Private Funds (SEC and CFTC regulated) Investment advisor or CTA/CPO >$150MM regulatory assets (or >$1.5 Billion large funds) Reporting Large funds 60 days after end of quarter Others 120 days after end of year

28. Disclosure under Form PF May use internal methodologies Must not be inconsistent with instructions Must be consistent with internal/client information Do not net longs and shorts Value is notional amount (delta-adjusted)

29. Form PF Stress Shocks Rates Yield in Pct. Stress Tested US Yield Curve Using SEC Form PF Shocks 4.5 4 3.5 3 2.5 2 Base Case (3, March 2013) up 25bps 1.5 dn 25bps 1 up 75bps 0.5 dn 75bps 0 0 36 72 108 144 180 216 252 288 324 360 -0.5 -1 Months

30. Threats to Viability

31. Reverse Stress Testing Supervisory Guidance (SR 12-7) Financial HCos., Banks, S&Ls >$10 billion assets CEBS (GL32) FSA (CP 08/24, PS 09/20)

32. Reverse Stress Testing New concept for banks FSA (UK) leading in requiring this Regulators like it but are silent on method

33. Reverse Stress TestingDefined assume a known adverse outcome then deduce the types of events that could lead to such an outcome. (Federal Reserve Board SR 12- 7, p. 12) Sounds simple, but

34. Reverse Stress Testing History FSA FSA Proposed BIS Principles Requirements US SupervisoryCRMPG III Rules for Sound UK banks go Formalized Guidance 2008-08 (CP08/24) Stress Testing live 2011-12 (PS09/20) 2012-11 2008-12 2009-05 2010-12

35. Reverse Stress TestingIllustrationMirzai & Mller. 2013. On Reverse Stress Testing.Intelligent Risk, 8-11. Pick critical loss level (CLL) Obtain 30K samples from joint distribution of risk factor returns Revalue portfolio 30K times Only look at those samples where portfolio loss > CLL By CaitlinJo [CC-BY-3.0 (http://creativecommons.org/licenses/by /3.0)], via Wikimedia Commons

36. Reverse Stress TestingIllustrationMirzai & Mller. 2013. On Reverse Stress Testing.Intelligent Risk, 8-11. Can we find economic meaning in these large loss samples? First, look for statistical commonalities using k-means clustering Second, relate cluster behavior to market risk factors through heuristic analysis

37. Reverse Stress TestingIllustrationMirzai & Mller. 2013. On Reverse Stress Testing.Intelligent Risk, 8-11.

38. Reverse Stress TestingIn sum: immature artRecent research collected at www.Gloria-Mundi.com; search on keyword phrasereverse stress.