Time to get back to the real business of stress testing?

Bank supervisors should focus on improving internal stress-testing all year round

Testing times: stress tests might be more effective if conducted internally

Every year, college students await the results of their exams with sweaty palms, furrowed brows and knotted stomachs. For some, leaps and screams of joy will follow. For others, the final outcome may bring a sigh of blessed relief, or tears of bitter disappointment.

Bank risk and compliance teams may find those feelings familiar. In the US, the Federal Reserve Board has conducted the Comprehensive Capital Analysis and Review in its current form each year since 2011. In the European Union, authorities have conducted continent-wide stress tests for four of the past six years, and banks are now gearing up for another in 2016. The Bank of England began its regular annual stress tests in 2014. Other jurisdictions, such as Singapore, have adopted a similar approach.

Naturally, the glare of analysts, investors, journalists and others will be on the winners and losers. Will the biggest US banks meet the strict criteria demanded by the Fed? What about specialist lenders? Might the EU tests reveal any nasty surprises about sovereign debt? How will Greek and Italian banks fare? The costs of failure – in terms of regulatory censure, plummeting stock prices and investor opprobrium – can be high indeed.

That means the scale of these exercises – and the attention banks and supervisors dedicate to them – is enormous. In the US, modelling and valuation experts tell Risk.net the tests have created "a perfect storm of pressure", leading to high levels of staff turnover and burnout at some institutions.

Is that attention being well-spent? In a survey conducted earlier this year by consultancy EY, many banks complained "about the sheer amount of time and resources being devoted to the supervisory-led stress tests in some countries, which may occupy resources that could otherwise be used for stress testing firm-identified specific risks". Notably, the same survey found stress testing was only "somewhat incorporated" into strategic decisions by 55% of respondents, and little more than a third used stress testing for business-unit planning.

There are some risk managers, such as Paul Berry, chief risk officer of Mizuho International, who believe supervisory stress tests can serve as a useful adjunct to banks' own internal stress testing. But that is far from the consensus view. For others, the sighs, tears and screams of joy would be better saved for the real task of integrated internal stress testing.

What if supervisors took the resources they currently expend on the annual tests and used them to push banks towards refining and enhancing their own internal stress-testing programmes? Importantly, that would include promoting a proper integration of stress testing with strategic decision-making. The resulting improvement in risk management would be a continuous, all-year-round affair – not just a one-off attempt to impress supervisors with sparkling 'A' grades.