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Preparing for the 2014 EBA Stress Test Best Practices for Regulatory Stress Testing & Capital Modeling

Cayetano Gea-Carrasco, Moody’s Analytics, Stephen Clarke, Moody’s Analytics , Andy Condurache, PRMIA Originally presented as a part of a Moody’s Analytics and PRMIA webinar | April 29, 2014

2 Preparing for the 2014 EBA Stress Test

Welcome PRMIA Members

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Contents

1. Regulatory Overview

2. The 2014 Stress Test

3. Collateral Re-evaluation

4. Challenger Models

5. Data & Reporting

6. Q&A


Regulatory Overview 1


Global Regulatory Stress Testing Pressures Intensify Across Regions

Source – Moody’s Analytics market research and own analysis as of April 2014

EMEA

2013 2014 2015 2016 2017 2014 2015 2016 2017

CRD IV/CRR

CCAR/DFAST ST

EBA / ECB ST

B3/ CRDIV

Volker Rule

Review of trading book (market risk)

Large exposures/ concentration risk

Basel 3 (IRB) Vickers Reform

LEI

Review of Securitization rules

LCR framework

Basel 2 Basel 3

Global systemic risk report (FED)

Basel 3

UK FDSF Basel 3 (STD)

Stress tests FBO

Cover Bonds Rule 3







LEI

LEI

Basel 3

RBC 2/ ERM Ins. Inv.req

CROSS IBA

Superann. Req. Ins Prud. Stand

SAM

Full Solvency II

Solvencia II

SII-like P1 BMA

ORSA

SST

ORSA US

AIFMD

CRDIV AM?

MIFID II

UCITS Liquidity Stress Test

MMF Internal Ratings/ST

CCP EMIR

G-SIIs rules

G-SIIs rules

G-SIIs rules

SIFI surcharge & risk mgt



UK ICAS

NIMM

NIMM

COREP/ FINREP

ECB CR4

IFRS 4,9

LCR LCR

Insurance Capital Standard



Interim Measures

SII Interim Measures

NIMM

CCAR/DFAST ST

1.For transition to CRD IV / CRR 2.Under the EU CRR the LCR will be implemented faster than originally envisaged under Basel III. The timetable will be: 60% in 2015, 70% in 2016, 80% in 2017 and 100% in 2018 3.ECB Loan-level Reporting Requirements for Asset-backed Securities Backed by Credit Card Receivables 4.ECB Comprehensive Review: Portfolio Review, Asset Quality Review and Stress Test

Capital Plan Submission1

CRR LCR2

CRR LCR2

Qatar Insurance Prudential rules

IRDA risk-based solvency

Capital Rules & Final Market Risk Rule)

BoE / PRA ST (Top 8 banks)

BoE/PRA ST (Top 8 banks + Mid sized + SIFIs)

Internal Ratings

ICAAP

ICAAP / ILAAP

ICAAP / ILAAP

ICAAP / ILAAP

CCAR/DFAST ST

CCAR/DFAST ST

ICAAP

ICAAP

ICAAP

Retail Banks ST

FSA ST

FSA ST

FSA ST

Blue – Stress Testing-related Regulatory Requirements

Black – Other Regulatory Requirements

BoE / PRA ST

ICAAP

EBA/ECB ST

FI/Riksbank ST

FI/Riksbank ST

FI/Riksbank ST

Retail Banks ST


United States vs. Europe – The Core Requirements of Stress Testing Regulations are Aligned Across Regions

Eurozone United Kingdom United States

Regulatory Body

Coverage

Disclosure

Modeling Approach

Frequency

Corrective Measures / Use of Outputs

Data Requirements / Reporting

Scenarios

EBA / ECB / NCA 1 BoE / PRA1 Federal Reserve

Annual Annual (regulator-led); semiannual (bank-led)

Annual (2009-2011 EBA); 2014 (ECB)

Largest UK Banks & Building Societies

Source – Moody’s Analytics

Public Disclosure of Results Public Disclosure of Results Public Disclosure of Results (Bottom-Up)

Bottom-Up & Challenger/Top-Down; Firms’ Own Models

Bottom-Up /Granular; Firms’ Own Models

Input Capital Adequacy CRDIV & firms’ PRA buffer; FPC Tool5

Common Stress, Bespoke Firm Stress, Common Baseline

Bottom-Up; Firms’ Own Models; Dynamic Projections

FDSF4 – Historical, Year-End Data & P/L Projections

FRY Reports – A/Q/M Data; P/L Projections

Historical/AQR Data – Core (ADC, TR, CSV) & Additional

(CSV) Templates2,3

Largest Eurozone/Significant Banks (approx. 128 banks)

BHC&FBO6; assets > than $10bn (DFAST), $50bn (CCAR)

Baseline, Adverse, Severely Adverse; Firms’ Scenarios

Input Capital Plan, Approval by Fed; Dividend Planning,…,etc.

Regulatory Baseline, Stress Scenario

Recapitalization Plan

1.European Banking Authority (EBA), European Central Bank (ECB), National Competent Authorities (NCA), Bank of England (BoE), Prudential Regulation Authority (PRA) 2.Asset Quality Review (AQR) 3.Advanced data collection (ADC), Transparency (TR) and Calculation, Validation & Support (CSV) Templates 4.Firm Data Submission Framework (FDSF) 5.Financial Policy Committee (FPC); Capital Requirements Directive IV (CRD IV) 6. Bank Holding Companies (BHC), Foreign Banking Organizations (FBO)


The 2014 Stress Test 2

Preparing for the 2014 EBA Stress Test

Structured Corporate CRE C&I Retail

Forecast RWA

Required Capital

Forecast NCO / ALLL

Forecast Other Losses

Forecast Net Interest Income

Forecast Non-Interest

Inc / Exp

PPNR / PPNP

Changes to Available Capital

Business Forecasting

Models

Forecast Positions

P & L Models

Financial Planning & Analysis

• Other revenue • Op losses • Trading losses • Counter-party

losses • Other expenses

Forecast Positions

Treasury / ALM

• Base Runoff • New Business

Interest Income / Expense Models

Market Risk

Strategy / Risk

Appetite

Regulatory Reports

Key Performance Indicators / Balanced Scorecard Variables

Source Database

Source Database

Source Database

Current Positions Regulator Scenarios

Stress Testing Inputs

Economic Variables and Alternate

Scenarios

Pricing Curves

C & I

Credit Models

CRE

Mortgages

Credit Cards

Auto

Other

Forecast Positions

Op Risk

Market Risk

Risk

8

8

The Stress Testing Calculation – The Big Picture


Comprehensive Review – Preliminary Timelines

Phase I The ECB is appointed as the SSM – Supervisory

Risk Assessment Process (SRA)

Publication 2014 Stress Test Scenarios

European Systemic Board/ECB/EBA

ECB fully assumes the supervisor tasks in the

Eurozone One year after being

appointed SSM – Publication Comprehensive Assessment

Results

Q1 2014 Q2 2014 Q2/Q3 2014 Q4 2013 Q4 2014

Phase II Asset Quality Review

(AQR) – ECB publishes AQR manual & EBA

publishes Stress Test manual

Phase III EBA Stress Test

Results ST/AQR Published (October)

2015 – Resolution Being Initiated

For those banks unable to raise capital privately after

the CR


The 2014 European Stress Test will be Administrated by the EBA; Part of the ECB Comprehensive Review

Static Balance Sheet

2013 Consolidated, Year-End Data Same Business Mix No currency Effects No workout of defaulted assets

Harmonized NPLs

Definitions

128 Banks

Insurance Activities Excluded

22 EU Members

Baseline &

Adverse Scenarios

Country Specific (NCAs)

Hurdle Rates 8%

CET1 Baseline,

5.5% Adverse

Transitional NCAs may Assess Fully

Loaded AT1/AT2 Conversion

Trigger 5.5%

Performing Non-Performing

Forbearance Defaulted


Key Aspects – Risk Coverage, Treatment & Disclosure

Highest level of consolidation

Trading & Banking books

Operational, Credit, Market, Sovereign risk, Securitisation, Funding Cost

Additional risks may be requested to be assessed by the NCAs

Disclosure will be consistent with the 2011/2013 EBA stress tests

Additional disclosure about capital, sovereign holdings & risk exposures

Trading book & Available-for-Sale Portfolios

MtM

Sovereign Portfolios

HtM

Recalibration of the RWAs


Key Aspects – Bottom-Up Methodology

Macro scenarios released today

NCAs may add country-specific variables to the scenarios

Credit Risk Methodology (Complex)

Point-in-Time; Caps & Floors

Model the default of a counterparty

Linkage macro economic scenario with default & loss parameters (provisions/RWA)

Market Risk Methodology (Simple)

Common set of stressed market parameters will be applied

IRC and CVA will be stressed

Uncertainties

Backstops, remediation actions & how to meet capital shortfalls/raise capital

Final methodology, dates, regular exercise, Sovg. filters, definition of the scenarios


Key Aspects – Scenarios

The scenario is triggered by increased global bond yields, worsening credit quality in troubled countries, lack of reforms, and a weaker banking sector

Output in euro zone declines 0.7% in 2014 and 1.4% in 2015. The corresponding declines in the U.K. are 0.8% and 1.3%

One-year euro swap rates rising 115 bps above baseline in 2014. In the euro area, house prices decline to 11% and stock prices 18.1% below the baseline forecast in 2016. Disinflation is experienced in many countries and the euro zone unemployment rate peaks at 13.5% in 2016

In the terms of a peak-to- trough decline, the stress scenario features a milder recession as compared to Severely Adverse Scenario published by the Federal Reserve for the CCAR exercise last year or the Anchor scenario generated by Prudential Regulation Authority in the U.K.


Expectations from Regulators – Effective Stress Testing Programs

Stress Testing Infrastructure

Dedicated Resources

Governance Framework

Stress Testing Methodologies

Reverse Stress Testing

Capital & Budgeting Planning

Contingency/Recovery/Resolution Planning

Scenario Analysis

Sensitivity Analysis

Management Actions

Risk Appetite


Collateral Re-evaluation 3


Level III Fair Value Exposure Review as part of AQR/Comprehensive Assessment

Independent Revaluation

• Revaluation of Level 3 Non-Derivative Assets

Process and Model

Review

• Trading Book Core Processes Review • Level 3 Derivative Pricing Models

Review

Each NCA bank team must carry out the Level 3 Fair Value Exposures Review, which is divided into two main components.


Revaluation of Non-Derivative Assets Requires Independent Valuations of Multiple Illiquid Assets at both Asset and Portfolio Levels The most material assets in each material asset class have been sampled across the trading and banking books and will be independently revalued by the NCAs and their contracted third parties.

Fair-Valued Loan Portfolios

Level 3 Single Name Bonds

Level 3 Securitisations

Held Real Estate

Part. & Indiv. PE

Investments

Significantly lower values from the independent revaluation will lead to adjustments in carrying amounts and increases in reserves.


Level 3 Valuations Require Multiple Assumptions with Limited Observable Data: Securitisation as an Example

Calculate Final Price Fundamental Cash Flows Generated from Above

Assumptions Market-Implied Discount Rates based on Some

Observable Information

Forecast Tranche Cash Flows Using Waterfall Models Transaction-Specific Capital Structure & Payment

Rules Transaction-Specific Triggers, Reserve Accounts,

Liquidity Facilities, etc.

Assess Counterparty & Optionality Outcomes Forecasting Counterparty (e.g., F/X & IR Swaps,

Liquidity Facility Providers) Behaviour Issuer and/or Investor Call Options

Forecast Future Underlying Collateral Performance Historical Performance versus All Similar

Collateral Historical Correlation with Macroeconomic

Variables and Forecasted Economics

Uncertainty is embedded in each assumption at each step of the valuation process.


Slight Changes in Assumptions During Revaluation can Result in Large Changes in Values

Seemingly innocuous changes in assumptions (for example default and prepayment vectors) can drive significant movements in cash flows and final prices

0%

20%

40%

60%

80%

100%

1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

Collateral Loss

Tran

che

Prin

cipa

l R

etur

n

Collateral Loss ∆1% Tranche loss ∆100%

Many banks implementing internal Challenger Models in preparation to uncover issues ahead of external/regulatory challenges


Challenger Models 4


Understanding Challenger Models Regulator: “…challenger model is a prudential measure to enable regulators a quantitative challenge of

the bank’s model and its calibration”

Bank: “…challenger model is a prudential measure to enable senior management a quantitative challenge of the business’ forecast and loss/hedging’s assumptions under stress”

Part of the AQR & Stress Tests

CVA, Cure Rate, LGL, LGI, PI, Provisions

Usually aligned with accounting requirements

Top-down or bottom-up

Statistical/actuarial versus cash-flow/competing risk

Extreme care must be applied towards general, portfolio-wide approaches

Benchmark bottom-up results (focus on level, not on value) / outliers

Provide floors & caps metrics

Proper Calibration & enough Data History adapted to the business model are key

Banks have raised concerns about those Challenger Models used in the AQR


Data & Reporting 5


The Data Collection Process for the AQR & Stress Test is Novel & Unique; Very Intensive in Resources

Very close linkage between the AQR and the Stress Test

New Segmentation for Clients & Exposures in the Banking Book that does not correspond to NACE codes or risk sectors

Notional amounts in the Trading Book must be re-valued as at December 31, 2013 using IFRS 13 hierarchy

More than 12 different asset classifications and +150 criteria for the Real Estate portfolio

Application of the 2013 EBA Forbearance & Performing/Non-Performing definitions for the Banking Book – First FINREP application in September 2014

Decomposition by files of the accounting collective provisions is not common in all the EU countries


Institutions Are Requested to Submit Core Templates; Additional Templates may be Requested by the NCAs

Core Templates

ADC – Advanced data Collection

TR – Transparency

CSV – Calculation support &

validation data

Additional Templates

CSV – Calculation support &

validation data



Core Templates

Advanced data collection

Transparency

Calculation support &

validation data



validation data

Advanced Data Collection – Credit Risk Credit Risk

Balance Sheet

COREP – driven

Standard & IRB Methods

Exposures

PD, LGD, RWAs

Provisions, Defaulted & Valuation



Core Templates


Transparency


validation data



validation data

Transparency – Exposures & Solvency CR 2014 Baseline & Adverse

CR 2015 Baseline & Adverse

CR 2016 Baseline & Adverse

CVA

Securit BB, TB Standard

Securit BB, TB IRB

RWA by Risk Type

Capital ratio & Solvency

Exposures



Core Templates


Transparency


validation data



validation data

Calculation Support & Validation – Market/Credit/Funding Risk

Sovereign

RWA Evolution, Standard, IRB, Trading

P&L Evolution

Security Summary

Capital, Restructuring

Market Risk

Capital & RWAs Projections

Sovereign Risk


Calculation Servers

Integrated Risk & Finance Infrastructure is a Necessary Condition

Data Mart

Results Data Admin

TL Platform

Historical Data Series

Bank Source Systems

Market And Credit

Data

Workspace

Workspace

Workspace

Data Quality Checks, GL Reconciliation Adjustment & Audit

Advanced security, access management, and audit features

Regulatory and Internal Reporting

Run stress tests

Capital & RWA Planning

Scalable pool of computer resource, reducing calculation time

Supports multi-source data feeds - synchronised or not

Complete data loading platform


Data & Infrastructure are the Major Building Block for an Effective Stress Testing Framework – Wish List

When implementing and automating the stress testing framework, data centralization, data quality, and systems’ integration is probably the most time-consuming and costly task

Enterprise-wide View – Consistent view at a group and subsidiary level; meet regulatory requirements across jurisdictions

Multiple Models (internal & third-party vendor) – Development and deployment of multiple models (top-down, bottom-up) from different stakeholders

Cost-Effective – Internal build is usually too costly, too slow and not reactive enough to support changing requirements

Scalability, Maximizes Return-on-Investment – Highly configurable framework to support changing and varied methodologies

Drill-down & Auditing Capabilities – Users are able to drill-down at a loan level data; audit the stress testing’s results and end-to-end workflow

Off-the-Shelf Regulatory Reporting – Produces stress testing regulatory reporting and reconcile results across jurisdictions


Q&A 6


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