Stress Testing for Risk Control Under Basel II

Front Cover......Page 1
Stress Testing for Risk Control under Basel II......Page 4
Copyright Page......Page 5
Table of Contents......Page 6
Preface......Page 12
Warning......Page 16
Part 1 Stress testing defined......Page 26
1.2 Risk distributions and extreme events......Page 28
1.3 Model uncertainty in simulation and testing......Page 31
1.4 Stress testing and the need for transparency......Page 33
1.5 Stress testing and confidence intervals......Page 36
1.6 Advanced testing methodology for better governance......Page 40
1.7 An introduction to the role of information technology in gaining competitiveness......Page 42
Notes......Page 45
2.2 Risk defined......Page 46
2.3 Risk associated with the counterparty......Page 49
2.4 Market risk and its variants......Page 52
2.5 Risk appetite and risk aversion......Page 55
2.6 Systemic risk and event risk......Page 59
2.7 Developing a system for risk management......Page 61
Notes......Page 64
3.2 Stress testing defined......Page 65
3.3 Advanced testing and new financial instruments......Page 68
3.4 What is the benefit of stress testing?......Page 70
3.5 Scenarios, sensitivity analysis and statistical inference......Page 73
3.6 Capital at risk under extreme conditions: an example......Page 75
3.7 Stress testing and the devil’s advocate......Page 78
3.8 Advice on implementing the stress test......Page 81
Notes......Page 83
4.2 The need for a scientific approach......Page 85
4.3 Science and the scientific method......Page 88
4.4 Fundamentals of stress analysis......Page 91
4.5 Case studies with scenario analysis......Page 94
4.6 Using the Delphi method......Page 96
4.7 Stress evaluation through sensitivity analysis......Page 99
4.8 Fundamentals of statistical inference......Page 101
Notes......Page 104
5.2 Worst cases happen when chance meets unpreparedness......Page 105
5.3 A bird’s-eye view of worst case analysis......Page 107
5.4 Impaired claims, credit risk and worst case......Page 109
5.5 Why are worst case drills important?......Page 111
5.6 A catastrophe drill undertaken by the International Monetary Fund in 2002......Page 113
5.7 The Federal Reserve’s ‘new bank’ and the carry trade......Page 115
5.8 The nature of worst case drills is polyvalent......Page 117
Notes......Page 120
6.2 Managing a successful technology effort......Page 122
6.3 Innovation and survival of the fittest......Page 124
6.4 A phase-shift technology strategy......Page 128
6.5 Re-engineering information technology is not an option; it is a ‘must’......Page 131
6.6 Projecting and implementing an enterprise architecture......Page 134
6.7 Strategic planning should account for information technology’s deliverables......Page 138
Notes......Page 142
Part 2 Stress testing probability of default, loss given default and exposure at default......Page 144
7.2 Volatility defined......Page 146
7.3 Keeping volatility in perspective......Page 149
7.4 Improving volatility models through heteroschedasticity......Page 153
7.5 Procedural insufficiency among financial institutions and individual investors......Page 156
7.6 Algorithmic insufficiency: a case study with value at risk......Page 157
7.7 The volatility of credit ratings: a case study with General Motors and General Motors Acceptance Corporation......Page 161
7.8 Risk estimates based on volatile probability of default......Page 165
Notes......Page 168
8.2 Credit risk defined......Page 169
8.3 Credit standards and default likelihood......Page 172
8.4 The discriminatory ability of power curves......Page 175
8.5 The predictive power of distance to default......Page 178
8.6 The risk of unwillingness to perform......Page 180
8.7 Case study: the stakeholders of TeleDenmark......Page 183
8.8 A lesson for stress testers: loss of creditworthiness has many fathers......Page 186
Notes......Page 188
9.2 Probability of default and liquidity stress testing......Page 190
9.3 Concentrations of exposure and credit risk measurement......Page 194
9.4 Probability of default and stress probability of default......Page 197
9.5 Estimating probability of default through probability of default buckets......Page 200
9.6 Errors in probability of default estimates and the role of benchmarking......Page 203
9.7 The many aspects of confidence placed on a test......Page 206
Notes......Page 208
10.2 Loss given default and exposure at default......Page 210
10.3 The challenge of computing stress loss given default......Page 212
10.4 Stress loss given default and ability to perform......Page 215
10.5 Stress exposure at default......Page 218
10.6 Point-in-time and through-the-cycle probability of default......Page 221
10.7 Stress testing legal risk......Page 223
10.8 Stress testing other operational risks......Page 226
Notes......Page 228
11.2 Counterparty credit risk......Page 229
11.3 Methods for handling counterparty credit risk......Page 231
11.4 Expected positive exposure and cross-product netting......Page 233
11.5 Maturity parameters......Page 236
11.6 Credit risk mitigation: collateral and haircuts......Page 237
11.7 Credit risk mitigation: new techniques......Page 241
11.8 Double default: general and specific wrong-way risk......Page 243
Notes......Page 246
Part 3 Expected and unexpected losses......Page 248
12.2 Bird’s-eye view of expected and unexpected losses......Page 250
12.3 Stress testing regulatory capital requirements for expected losses......Page 253
12.4 Back to basics: do we know the reason for credit losses?......Page 256
12.5 Contribution of rating agencies to prognostication of expected losses......Page 258
12.6 How to handle expected losses from lending......Page 261
12.7 The results of the fifth Quantitative Impact Study......Page 264
12.8 Thinking about models for credit risk......Page 266
12.9 Strengths and weaknesses of credit risk models......Page 268
Notes......Page 272
13.2 Unexpected risks confront every enterprise......Page 273
13.3 Impact of macroeconomic developments......Page 276
13.4 Risk drivers targeted by macro stress tests......Page 279
13.5 Stress testing macroeconomic risks and opportunities......Page 281
13.6 Stress testing financial instruments: a case study with interest rates......Page 283
13.7 Stress testing for unexpected losses from business risk......Page 287
Notes......Page 291
14.2 Economic capital for credit rating and unexpected losses......Page 292
14.3 Capital beyond loan-loss provisions......Page 295
14.4 Wrong correlations magnify unexpected losses......Page 299
14.5 The missing algorithm for unexpected losses......Page 301
14.6 Qualitative scenario for unexpected losses......Page 305
14.7 The board needs tools to appreciate the value of assets......Page 307
Notes......Page 310
15.2 Hedge funds: an industry born in the 1940s......Page 311
15.3 Stress testing highly leveraged institutions......Page 313
15.4 The proliferation of hedge funds and testing their risks......Page 315
15.5 The exposure of credit institutions to highly leveraged institutions......Page 317
15.6 Supervision of highly leveraged institutions......Page 320
15.7 Highly leveraged institutions at the peak of their might: No! to regulation......Page 322
15.8 The drama unfolds: highly leveraged institutions fire the boss of the Securities and Exchange Commission......Page 325
Notes......Page 327
16.2 A concept for better corporate governance......Page 328
16.3 The contribution of strategic thinking......Page 330
16.4 Use of threat curves and S-curves: an example from the insurance industry......Page 332
16.5 An oil industry case study on risk factors and their background......Page 335
16.6 Pillar 2 and Pillar 3 require an enterprise-wide risk discipline......Page 339
16.7 The exercise of market discipline is a significant step in supervision......Page 341
16.8 Use of stress testing by central banks and regulators, for better governance reasons......Page 343
Notes......Page 346
Index......Page 347