Earlier I had blogged about the pendulum shifting away from the light touch supervision mode to a much more prescriptive regulatory environment.

The new stress testing guidelines in Europe seem to be good indication of the trend. With most stress testing models failing to reflect the current crisis, many regulators are reviewing the stress testing guidelines and methodology.  

Typically in most markets, the stress testing is performed at three levels:

1.Institution level
2.Regulator’s stress testing of an institution
3.Industry-wide Systemic-level stress testing

Most of the changes focus on the first level of stress testing within institutions, but there is certainly thinking on other two aspects as well. Purely going by the headlines, the Risk Managers in Europe must be quite stressed by the ongoing consultations around stress testing regulatory mandates.

Let us look at CEBS & FSA in this blog:

FSA’s Reverse Stress Testing guidance:

For the first time, banks will need to implement reverse stress testing methodology that will help identify and assess the conditions and scenarios that will  most likely impact its business viability and lead to its collapse.

So the banks will have to trace back from the worst case scenario possible to zero down on factors that led to the expected point of collapse.  As a result, banks are expected to be able to identify the highest risk factors and exposures of their current business models.

The FSA stress testing guidance is also revised to make it a much more integral part of risk management accountability at senior levels.  And, banks are expected to build/enhance a robust stress testing and scenario analysis infrastructure to assess capital needs in a crisis environment.

CEBS Stress Testing guidance:

The new stress testing guidelines need to be carried out at portfolio, business and firm-wide levels, with specific focus on senior management and board-level engagement. They have to make sure the testing is sufficiently severe and in tune with overall strategy.

A key question to evaluate for the industry is whether it is realistic to expect the boards to have the expertise to oversee, challenge and approve stress tests, given the  "quantitative “ aspects.

The guidance, to be used under Pillar II of the Capital Requirements Directive within the Internal Capital Adequacy Assessment Process (ICAAP) and the Supervisory Review and Evaluation Process, does potentially create duplication with the requirements proposed by national supervisors, and those within Pillar I.  A good example being liquidity risk.

Another key concern is the recommended June 30th implementation deadline for complying to the more regulated stress testing methodology. Is too much prescriptive guidance good or bad?  I do not know the answer. Does it start to negate the principle that every institution is best managed with their respective Risk models fine tuned to their business model?  We will have to watch and see what the industry responses are to the consultations be end March.

So, Risk Managers, get busy refreshing your 101 training material for stress testing courses for your Board.