Stress testing in all its forms is a smart asset management practice. While annual Dodd-Frank stress tests at big banks get headlines, stress tests are implemented by investment managers across sectors to measure sensitivity to negative market conditions and structure portfolios accordingly.
Stress tests can also be performed on non-portfolio investments that make up a significant part of your net worth, such as properties or companies, as part of comprehensive wealth management plans.
Risk Assessment
Risk analysis means finding any risks that might harm the return of your portfolio based on historical data analysis and model and simulations to calculate probable and high-risk possible losses.
Supervisory recommendations advise that banks with strong non-owner occupied CRE and subprime concentrations stress test these exposures regularly; community banks looking to improve their risk controls might benefit from reviewing how local economic conditions or collateral values could impact loan concentrations and watch list credits.
As one way to gauge resilience to negative situations, banks inevitably use firm-run stress tests, done at least once a quarter and delivered by strict reporting deadlines. These tests consists of quantitative forecasts of balance, capital and loss under different macroeconomic situations retrieved from reporting templates retrieved from other systems but the procedure is inefficient if models are lost or workflows are too complex; which results in inconclusive and unreliable forecasts that make it ineffective and the exercises inconsistent and flawed.
Scenario Analysis
Scenario analysis is a way of determining what multi-asset portfolios will be at risk in varying market scenarios. Scenario analysis is similar to sensitivity analysis as it attempts to figure out what the impact of change of dependent variables will be when the values of dependent variables are changing in response to changes in independent variables.
Risk analysis is an integral part of today’s risk management, helping to guide portfolio design, concentration risk and factor sensitivity. And Risk analysis is an essential part of client communication to answer the tough questions and establish team and investor trust.
It’s not easy to write situations that are both plausible and natural. Having a middle ground is important, because more abstract or negative scenarios can misrepresent or overlook key facts that are less readable and useable, which can lead to poor decision-making or not adequately preparing for unpredictable market forces.
Hedging Strategies
Stress tests use risk models to determine how a portfolio would react to unforeseen market corrections. Ascertaining how sensitive it is to inflation or interest rate rises and by modeling several situations, this model offers some recommendations on how to reduce losses by suggesting hedges that reduce losses.
Banks need to conduct capital stress tests on a regular basis. These in-depth studies calculate if they will have enough capital in case of a crisis like recession or stock market crash.
Stress tests are also good for those about to retire or who have a lot of debt they’ll have to settle when the market crashes. Homeowners can apply risk tests to recognize potentially dangerous exposures such as overexposure to regional or local economic conditions or declining real estate prices – and leverage that insight into a valuable asset accumulation plan based on client risk appetite and goals.
Monitoring
Stress testing has been part of supervisory mandates for large banks since the financial crisis of 2008. It is aimed at determining whether existing financial resources including capital and liquidity, personnel, and internal systems are up to the challenge of bad conditions.
The first step towards a scenario is to pick out low-probability events that are possible, but not likely. One may consider the economic crisis slowing manufacturing or housing values dropping significantly, terrorist attack or unforeseen public defaults.
Community banks under $1B can benefit from stress testing by analyzing their portfolios for credit risk. The type of institutions usually have simplified portfolios and better insights into borrowers and the economy, so asset/liability management can help identify volatility and develop risk-based hedges – and leverage that information to make strategic investment decisions that are appropriate for their business objectives.
