Does Bank Stress Test Help to Mitigate Systemic Risk?

Abstract

The research proposal seeks to address the past practices subjected to the banking and financial institution to mitigate systemic risk by focusing on capital inadequacy. In the paper, we demonstrate how stress testing has been successfully used to curb bank opaqueness and quantify systemic risk, particularly under challenging scenarios similarly; the bank and financial supervisor are kept mindful of a possibility of a future adverse effect thereby helping to address any related economic instability. It also contributes to alleviating 'disaster myopia' while enhancing analytical capabilities of the banking system and to improve data collection. Finally, we also recommend several issues to improve the current stress testing practice. Some of the concerns include merging of the capital adequacy and liquidity, availing granular data. Once these systemic measures are implemented, it will assist in mitigating systemic risk which will lead to the promotion of financial stability in future.

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Keywords: systemic risk, stress test, financial system, financial crisis.

Does bank stress test help to mitigate systemic risk?

Introduction

The financial crisis witnessed in the world underscores the need for the interconnections in the banking and financial system. The banks and financial institution should address the problem of systemic risk by conducting regular stress tests. The risk is defined as a threat that affects the banks and spreads to the point that it impairs their smooth running of and leads a financial crisis (Pritsker 2015). By its systemic nature, the risk entails a multi-dimensional approach which is captured by the available measures in different ways. It is important to control both macroeconomic and financial stability to enhance to the general architecture of the financial supervision. For instance, EBA which stands for European Banking Authority plays a crucial part in the mitigation of systemic risks by conducting stress exercise. According to (Pederzoli, Torricelli and 2017), the EBA from 2011 has been carrying out stress test in the banking system to ascertain its resilience in case of an adverse economic situation (p. 11). The exercise is done based on the capital derived from a single bank and the asset ratio of the risk weight. The stress testing conducted by an individual bank is centered on the balance sheet provided by the bank or financial institution. The stress test is made possible by stressing several economic and fiscal conditions. However, the numerous efforts do not fulfill their aim. Besides, yearly, the Basel Committee on Banking Supervision (BCBS) and Financial Stability Board (FBS) usually publish a list that contains the number of assessed banking firms. The listing is done in consideration of a score that is dependent on the features of the bank. Stress testing is defined as the assessment of the impact of different circumstances on the financial position of the banking and financial systems. The exercise is an important tool for bank supervisors to attain their goal (Pederzoli, Torricelli and 2017), p.12. The administrator anticipates enough capital to cushion them under bad economic times. In the stress test, the ramification for a bank's financial strength is examined under various macroeconomic environments. The test is done while taking the bank's business model and exposure into consideration. The exercise has numerous characteristics. First, they concentrate more on a very adverse situation by offering tail risk information to the supervisor. Second, they provide a consistent supervisory standard across many banks. Third, the bank stress tests are disclosed to the public to minimize market uncertainty and build confidence (Johnston 2011), p. 5.

The research proposal seeks to examine how stress testing alleviates the risks of financial institutions. The measures of systemic risk proposed should be relevant and model-based. To this end, it is imperative first to develop a structure that incorporates a system that formalizes and measure crisis. Lastly, there is need to create an optimal policy, and in-depth analysis of the measure of crisis assessment would have performed in the financial crisis that began in 2007 and ended in 2009 (Johnston 2011), p.6. The importance of the analysis on the financial system will help to address the serious concerns about the business architecture and robustness. Also, it minimizes the opacity of the financial institution and reduces the asymmetric information among the market participants. Stress testing is an exercise that is mostly faulted because they do not fully cover their implementation plans; however, with proper analysis and implementation, it can be used as a tool to collect information and expand their quantitative analytical capabilities and holistic risk management practices.

The Rationale of the Study

The study will help to assess whether stress test done by banks helps to alleviate systemic risk. This is by analyzing the impact of stress testing on the workers in banks and whether or not the systemic risk is reduced. This study will show whether financial institutions can handle capital deficits in case a crisis arises in future.

Research Objectives

To assess whether stress testing mitigates systemic risks. Finding out whether there is any solution that stress testing brings to banks and other financial institutions are essential. The collected information will help bank expand their quantitative analytical capabilities and holistic risk management practices.

To identify common problems faced by banking firms that can undermine the overall stability of a financial system. Banks face related issues in their day-to-day undertakings which can be solved either partially or fully if identified.

To provide recommendations aimed at improving the current stress testing practice. This study will help come up with solutions to make stress testing more effective and efficient thus improving the current state of banks and other financial institutions.

Research Questions

• Are banks and financial institutions are prepared to handle capital deficit in case of a crisis in future
• What are the Stress scenarios designed for capital adequacy and systemic risk?
• Do banks have less incentive to sustain independent risk management systems
• What is the impact of stress testing in extenuating systemic risks?

Hypothesis

Stress testing is an exercise that is mostly faulted because the bank is not able to adequately cover implementation plans; however, with proper analysis and implementation, stress testing can help mitigate systemic risks.

Literature Review

Stress Testing

The exercise conducted by EBA intends to show how banks and financial institutions are prepared to handle capital deficit in case of a crisis in future. There are theoretical backgrounds that validate the use of MES to predict stress test. It is proposed to have a model that the regulator can assess the guidelines and the firm's information. The optimal policy that arises from the model entails tax that is linked to the contribution made by the bank to the general systemic risk that is quantified by loss incurred during the crisis. It clearly shows that if stress testing is done as per the set guidelines, it can reduce systemic risks. Besides, ex-ante is used as a tool for determining SES (Neretina, Sahin and De Haan 2014), p. 4.

In this review, the study will focus on what extent should the supervisory information be revealed. The openness of banking administrator varies across many banks. In some institutions, the disclosure of stress test outcome depends on the bank's economic efficiency. The effect of disclosing test results can be reduced by revealing aggregate instead of revealing each firm conclusion. Similarly, environment also affects the disclosure of stress test results. For instance, during crunch, there is need to release bank-specific results because every bank might have been changed differently. The supervisory authority can create value by unveiling both the stress test methodology and outcome (Neretina, Sahin and De Haan 2014), p. 13. Consequently, stress exercise yields disconnect between concepts that are associated with liquidity and stress testing's capital adequacy. For example, there are clear instances that show this disconnect. They include an exercise conducted by America's Federal Reserve Bank. The CLAR and BHCs: CCAR typically deal with liquidity aspect. Although these practices run by Federal Reserve have been made public, the latter has not yet been published (Hovakimian, Kane and Laeven 2015), p.13.

The research proposal will relate to this literature since the outcome of the stress test will be disclosed after examining the systemic risk of the banks. From the SCAP stress test conducted in 2009, the findings resulted in a notable reaction of the stock prices. Besides, under-funded banks witnessed worse results compared to the rest. In a similar study conducted in 2010 and 2011 by EBA, the outcome of the stress test was uninformative about the financial market situation in 2010. While in 2011, the findings were impacted by the methodology release (Festic 2010) p. 70. Therefore, the outcome will be taken into consideration since they are relevant to the mitigation of systemic risks.

The stress test exercise conducted by the Federal Reserve's CCAR in 2011 to 2013 is categorized as the micro-prudential supervisory stress test (Neretina, Sahin and De Haan 2014), p. 5. This test is done to ensure there is no homogenization of the stress test model that affects the credibility of the outcome, especially when alleviating the risks. The banks at times have less incentive to sustain independent risk management systems such as stress test, and they opt to embrace specification by Federal Reserve. These assessments were done after the crisis unlike the SCAP in 2009. In Europe, the tests conducted were not crisis management trials. They vary particularly on the emphasis on current risks and solvency, unlike the SCAP test that is dependent on the estimates provided by the banks. The stress exercise is mostly faulted because they do not fully cover their implementation plans (Neretina, Sahin and De Haan 2014), p. 14. However, despite these faults, good plans have been put in place to make the process is seamless and address the fundamental role of mitigating risks. As a consequence, stress test has become a crucial tool in the supervisory level approach to curb the future crisis.

Some regulators have advanced their models to deal with these matters. Nevertheless, the actions have not yet been incorporated into the first stress testing exercise. Some models have underscored the banks' variations and systemic impact of stress. For instance, Britain's Risk Assessment Model for Systemic Institution (RAMSI). It is worth to note that these necessities are supposed to be incorporated together with the regulation of solvency in an optimistic way. Although there are empirical relationship and presence of advancing theoretical basis, most of the regulatory tests continue to address separately capital adequacy and liquidity (Aikman et al. 2009) p.32.

Research Philosophy

The data collected to ascertain whether stress test mitigates systemic risks is collected, analyzed and used. Research philosophy contains the formulated beliefs and assumptions from the study. This is by use of paradigms such as positivism, realism, interpretivism, and pragmatism. Pragmatism research philosophy accepts a concept only...