Nov
23
2012

Are you making the most of stress testing?

 

Uncertain times call for sound credit decisions

Stress testing our consumer and commercial portfolios has become part and parcel of regulatory reporting in the aftermath of the credit crunch. With more robust stress test methodologies being required, the outputs can also be applied usefully to extract additional value across a number of other functions within credit risk management and financial planning. William Thomson, Experian Director of Economics, discusses the way ahead…

There has been increased focus by regulators, in recent years, both at home and abroad, over the vulnerabilities to consumer and commercial lending portfolios from alternative and even more extreme potential outcomes. These demands are not going to disappear and the level of detail demanded will only rise over time.

Unpredictable risks

Currently the UK economy faces a period of considerable uncertainty, with downside risks abounding from both domestic and international sources. The timing and severity of these risks are hard to predict. Financial prudence suggests the potential impacts these will have on your portfolios should be considered as part of the ongoing financial monitoring and planning processes, over and above just simply meeting a set of prescribed regulatory requirements around economic stress testing.

Adopting economic data for stress testing

So how do you get the most out of these economic stress testing exercises to ensure the appropriate capital requirement and levels of provisioning, while at the same time maximising your revenues associated with a given risk threshold? Well, the answer lies, to a large extent, in the economic data that you adopt for stress testing.

Using economic data and forecasts

At Experian we have long believed it is important to use more granular economic data, which more truly reflects the individual accounts within your portfolios. So instead of using national level macroeconomic data, where there is a homogenous economic impact on all individuals in the portfolio, Experian would recommend the use of economic data and forecasts at a granular geographic, sector and socio-demographic level, to bring the economic data and their effects closer to those felt by individual account holders.

Stable scorecard calibrations

By adopting these types of economic data into your credit risk modelling frameworks, our experience suggests scorecard calibrations remain significantly more stable over time with lower implied error rates, and in the stress testing environment itself, you can understand how a given economic scenario or set of economic stresses will affect accounts with varying magnitudes. These can then feed through into loss calculations and on into provisioning levels and capital requirements, which would form part of your stress testing regulatory submissions.

A clearer vision of your risk concentrations

On top of this, you can reap the rewards of significant additional outputs by adopting this more explicit and granular approach to stress testing. These benefits stem from a clearer vision of your risk concentrations within your portfolio both in a forward looking manner and also under different stressed environments. This will allow you not only to take mitigating action against identified vulnerable accounts, but also signal those accounts where up-sell opportunities are the most prudent, and indicate the characteristics, in terms of geographies and socio-demographic or industry profiles, which will make the best customer acquisition targets given your prescribed level of risk appetite.

Responsibly extending your portfolios

It is clear the lending environment will remain challenging in the coming years, and lenders will be asked to balance responsible risk management strategies against increasing consumer and commercial lending to boost the economy. Understanding the potential vulnerabilities to your portfolios, under various stressed scenarios and using more granular economic data, gives you the opportunity not only to meet your regulatory requirements in a robust manner, but also allows you to identify opportunities for potentially expanding your portfolios responsibly in these challenging times.

 

William Thompson

William is Director of Economics at Experian. He has worked for many years to help some of the world’s leading private sector organisations understand how economic change will impact their business portfolios.

During his career at Experian he has been helping customers apply economic forecasts and analysis to portfolio loss forecasting and stress testing.


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