How can financial institutions effectively assess the impact and depth of a recession?

Financial institutions have internal economic research teams that build short-, mid-, and long-term economic scenarios with different levels of assumptions. These scenarios are used for multiple purposes, such as:

• Forecasting revenues: Financial institutions can build economic scenarios with different levels of assumptions to forecast how much revenue they will generate in the future. This information can be used to make decisions about pricing and investment.
• Determining the cost of risk: Financial institutions can use economic scenarios to determine the cost of risk. This information can be used to set prices for products and services, and to manage their ownown risk exposure.
• IFRS provisioning: Determine how much to provision for loan losses under International Financial Reporting Standards (IFRS). This ensures that the financial instituion is adequately capitalized and has sufficient reserves to cover potential losses.
• Consequences on capital: Assessing the impact of different economic conditions on their capital requirements.

The economic research team must be very open to different assumptions, even the ones that the management may not want to see; it is important to consider all possible outcomes, even the negative ones, in order to make informed decisions. It is also part of the exercise required by the regulators; the economic research team needs the ability to build its own scenario on top of those requested by the regulator.

Data, and the accuracy of data, is necessary to assess the different impacts of a recession.

Accurate data availability will ensure financial institutions can assess their risks accurately.

Without accurate data, stress tests can be misleading and may lead to inaccurate conclusions. Financial institutions should use high quality data sources, reconcile data from different sources and have access to granular data to be able to identify and correct any errors. Modern data platforms, like Opensee, will ensure financial institutions have all the information necessary to improve transparency and accuracy of data for efficient risk management.

Why is stress testing important when preparing for a recessionary environment?

A recession is an economic shock that can have a significant impact on the activities of a financial institution. Without a precise stress testing department that analyzes each activity based on the assumptions of the macro scenario, some consequences could be easily forgotten.

A stress scenario is also an interactive exercise. From the first results of the stress test, the institution must ask itself what could happen in other organizations and other industries if they experience the same kind of stress, and what the potential consequences would be for the institution itself.

A stress testing department can help to identify and mitigate these risks. By conducting regular stress tests, organizations can identify potential risks and develop plans to mitigate them. This can help to weather a recession and emerge stronger on the other side.

In what ways can scenario analysis be used to prepare for the future?

The purpose of stress test scenarios is to mitigate the negative surprises that can occur for a financial institution. It is a way to assess the institution’s risk appetite and to identify potential risks. The stress test should be based on the risk appetite, which is defined by the board of directors in terms of P&L, liquidity, and capital.

There have been numerous examples where organizations have either not conducted stress tests or have conducted them inadequately. A recent example being Silicon Valley Bank which did not have a good model for deposits, which led to losses. Another example is a lack of ALM stress testing, which led to bad interest rate hedging.

Stress testing is a valuable tool for managing risk in a financial institution. It can help to identify potential risks and to take the appropriate measures to mitigate those risks. However, it is important to have a good stress test team. If the stress test team is not good, the stress test results may not be accurate. For example, the dividends stress test on the equity structured products during the Covid Period were not conservative enough.

How can financial organizations manage the combination of recession and high inflation?

• Spending enough time on what this scenario “means” and building consistent data assumptions from it.
• Managing liquidity carefully, ensuring there is sufficient liquidity to meet obligations and protect unsuspected outcomes.
• Monitoring economic conditions closely, identify and respond to potential risks.
• Efficiency of stress tests: Data accuracy, quality and accessible granularity are key for efficient and effective stress tests.

Why should financial institutions develop stress testing for worst case scenarios?

As mentioned above, financial institutions should develop stress testing for worst case scenarios because it can help them to:

• Identify and mitigate risk: By conducting stress tests, financial institutions can identify potential risks that they may not be aware of. This can help them to take the necessary steps to mitigate those risks before they cause issues.
• Maintain financial stability: Stress testing can help financial institutions to identify and address potential issues, therefore, assessing those risks earlier and building plans to mitigate them.
• Comply with regulations: Regulators require financial institutions to conduct stress tests. By conducting these, financial institutions can demonstrate that they are meeting regulatory requirements.