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Intelligent Risk - Volume 1 Issue 3 - October 2011

Mon, 07 Nov 2011 09:47:00 GMT

Introduction to Issue 3

Stress testing has long been recognized as an important tool in risk management. At the same time, doing it well remains a significant challenge. For example, the stress tests on capital adequacy conducted by the US Fed in 2009 are widely credited with calming the markets despite widespread skepticism about their rigor and transparency at the time. In contrast, as PRMIA Chair Carol Alexander points out below, many of the European banks that passed more recent and arguably stiffer stress tests were nevertheless punished by investors in the markets, presumably because the stress scenarios considered did not include the paramount concern of the moment – possible sovereign default within the Euro zone. Yet it would be hard to argue that there was better information about the state of banks back in 2009. So do stress tests work or not? As Yul Brenner memorably sang in the musical The King and I, “It is a puzzlement.”

Observers are right to be skeptical about stress tests. They are by definition selective and driven by assumptions. Designers of the tests necessarily prioritize some criteria over others – in much the same way writers select details to tell a story. And as with a good story well-told, selecting the right details illuminates, clarifies and focuses attention with remarkable efficiency. Conversely, selecting poorly makes for a distracting exposition and a dull read, assuming anyone pays attention at all. Worse, it may mislead or mischaracterize the facts at hand. Yet stress tests remain among the best tools available for identifying risks, and even imperfect stress tests reveal weak links in interconnected portfolios or funding chains.

Given the difficulty of selecting the right details in every case, most specialized fields develop “rules of thumb.” Here’s one from publishing: editors often refer to the “rule of three.” It works like this. Three highprofile events – three different celebrities wear similar outfits, three similar products are released the same week, three seemingly unrelated events have some common factor, etc. For an editor, these occurrences may constitute a “trend” that, in the hands of a decent writer, could sustain a story that grabs reader’s valuable attention. (Bonus points if photogenic celebrities are involved.)

Three also seems a magic number when it comes to stress testing. How often have you seen best/worst/most likely as the scenarios presented for consideration? More sophisticated versions exist as well, such as David Rowe’s discussion of stress-testing based on (1) history, (2) imagination and (3) “pessimisation.” (See the previous issue of Intelligent Risk for details.) David and other thought leaders can undoubtedly come up with additional worthwhile types of stress testing, but he settled on three. Risk managers and others continue to work hard to improve stress testing capabilities and quality. (For some examples check out Thomas Day’s article about lessons learned and emerging standards in stress tests.) At the same time, as professionals we should not dismiss our own rules of thumb lightly. An assessment by the European Central Bank found that key disrupters in the financial crisis, notably the seizing up of the funding markets between banks, were only included in bank stress tests by rule of thumb.1 One more thought: one of the earliest uses of the term “rule of thumb” was as an imprecise but reliable and convenient measure. It was subject to misuse of course, but that does not mean it is useless. Enjoy the issue and, as always, let us know what you think we are doing well and where we can improve.


Download Intelligence Risk HERE (pdf).






  • Systematic Risk — It’s Still All About the Data
  • Recovery and Resolution Planning — Asking the Right Questions
  • Five Downside Risks to the Global Recovery: Global Macroeconomic Outlook and Risks
  • IT Risk Evaluation
  • Stress-Testing: Lessons Learned and Emerging Requirements — The U.S. and European Banking Authority (EBA) Frameworks

National University of Singapore — Risk Management Institute

Stress Testing After the Crisis...and Before

PRMIA Munich

PRMIA Higher Standard Award Recipient Dr. Dan Rodriguez


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