Stress testing next on the agenda for Basel Committee

The quantification of risk has made great strides in the past decade, in no small part due to regulatory requirements under the Basel II framework. Even so, recent turmoil has highlighted several shortcomings in the ability of models to capture all risks, particularly during periods of extreme market stress.

In the raft of recommendations and critiques that have been released in the past year, a recurring theme has been the need for banks to improve their existing stress testing capabilities. In accordance with this, the Basel Committee’s risk management and modelling group is working on a paper that will address this issue.

“There is a realisation that economic capital, for example, does not adequately capture tail risk,” Klaas Knot, chairman of the risk management and modelling group at the Basel Committee and division director of supervision policy for the Netherlands Bank, told Risk. “These models need to be complemented by a stress testing regime that is sufficiently robust. This is one of the current focuses within the risk management and modelling group. Before the end of the year, we intended to release guidance on what elements are needed for an effective stress testing regime.”

Although Knot said it would not be the intent of the paper to prescribe specific scenarios, he did think that observations would be beneficial on the possible severity of market stresses. “Recent turmoil has proven more severe than many of the stress scenarios used by banks before the turmoil began: that is obviously a serious weakness in the industry that needs to be addressed," he added.

The move towards more qualitative analysis is supported by many respected risk managers, who say the shift is already happening even without regulatory pressure.

“Within the industry as a whole, there is an unprecedented and, in my opinion, welcome shift of focus towards coherent, self-consistent stress testing and scenario analysis,” remarked Riccardo Rebonato, global head of market risk and the quantitative research team at Royal Bank of Scotland. “To some extent, the regulators in recent white papers seem to be coming around to this idea, but many banks are embracing these approaches spontaneously.”

Meanwhile, the Basel Committee on Friday said that global supervisors endorsed its revised Principles for Sound Liquidity Risk Management and Supervisions, which was released for public consultation on June 2008.

The 36-page document outlines 17 principles for banks and supervisors, with the aim that firms establish a robust liquidity risk management framework into their overall risk management processes.

See also: Points of principle