Act Four – Evolving Stress Testing Scenarios in 2021: What Happens At the End Of Swan Lake?

By Harry Chopra, Advisor, AxiomSL, Mahim Mehra, Senior Risk Advisor, AxiomSL, Yang Zhang, Global Product Manager, Capital and Liquidity, AxiomSL

In all archetypal stories, there is a fight for good versus evil and there is no definitive conclusion about which side will win until the very end. In the case of Swan Lake, the question throughout is whether the sympathetic white swan Odette or the alluringly evil black swan Odile will dance her way to Act Four and emerge as the heroine. In the case of evolving stress testing scenarios, both those occurring now and those predicted for the future, the same uncertainty principle applies. In Acts One through Three of our series, we discussed the need for stress testing processes and technologies that firms can leverage to prepare for black swan events – like an unprecedented global pandemic – and other systemic or idiosyncratic disruptive forces to capital, liquidity, and risk management.

Distinguishing Nuances In Stressed Scenarios: Are We Seeing An Odette Or An Odile?

In the previous acts of this complicated ballet, we explored the difficulties of predicting which swan will appear amid a backdrop of unpredictable economic factors, unforeseen events, and systemic risks that can throw an organization or even an entire system off kilter. Thus, we concluded that organizations must be prepared for many possible evolving stress testing scenarios and approaches. Although they may at first seem to dance the same steps, Odette and Odile are different. The consequences of not grasping nuances can be daunting if organizations cannot flexibly tweak and adapt their stress testing processes to gain lucidity and insight into potential impacts. To address some of these nuances, we explored various topics in the previous installments:

All Good Performances Have An Encore

In Act Three we promised that there would be an encore to our series, but an encore to the series might not be the only thing that continues into 2021.

Act Four – Evolving Stress Testing Scenarios in 2021: What Happens At the End Of Swan Lake? This pandemic’s immediate effect and ongoing aftershocks have shown that a sudden, drastic reduction in global economic activity is entirely possible. This phenomenon was not only unprecedented but unpredicted. Moreover, given the frequency of recent crises – including the credit crisis of 2008-2009 and Covid-19 – it seems that black swan events might be becoming more the norm, not just once in a generation phenomena. Organizations need to be prepared for a full spectrum of stress scenarios. This is even more important now given that the lingering effects of black swan events could lead to economic uncertainty and volatility for years to come. In other words, black swans could be making way for grey swans. Elaborating on that assumption, we ask:

How can organizations fine tune their capital-liquidity-risk systems and processes to more flexibly accommodate flocks of swans and not just isolated fly-ins?

While the black swan Odile’s most recent performance may not be everyone’s favorite, it seems unlikely that we will vanquish her forever. After all, life does not mirror a fairytale about princesses and swans with good winning out in the end, and so the reality is that we must learn how to tame the black swan and be prepared to resist her evil charms by evolving stress testing scenarios accordingly. To gain flexibility, mastering some new dance steps might be the next move for 2021.

The Pas De Trois Of Challenges: Achieving Data Nirvana, Building Unbreakable Systems, And Balancing Known Unknowns

Achieving Data Nirvana
To adequately confront the challenges of incorporating new and diverse stress testing scenarios into existing capital-liquidity-risk systems, accurate, transparent, and consistent data is essential. Institutions need to perform more calculations, scrutinize more analytics, and generate more reports – and perhaps accomplish this with fewer resources. While more more more might be the general theme, mere data volume is not enough. Given the increased frequency of black swan events, the right data must be transparent, accurate, and understandable – to facilitate deriving insights.

Organizations must be able to respond to all these needs leveraging systems that are flexible and can ‘pivot’ to accommodate new events when required. A system that accounts for counterparty connections becomes critical, as does having a central data repository. Whether or not an institution is able to access this flexibility may determine their fate. They are faced with the challenge of what to do and what not to do. Decisions to determine business models will need to be fine-tuned based on how the economic environment and regulations are evolving – but this type of fine tuning and achieving data nirvana can only be done correctly if data is reliable, accurate, and transparent.

Building Unbreakable Systems
At this juncture of the ‘Covid-19-landscape-altering’ black swan event, it is difficult to determine which institutions are best positioned to adjust their business models. For example, changes to regulation requirements such as those related to the internal ratings-based approach (IRB) will have the greatest effect on big banks – both in terms of timing and impact. By contrast, certain medium-sized banks already using the standardized approach (SA), will be less impacted and may therefore benefit versus their larger counterparts. Who will win and who will lose may be dependent not only on the flexibility of their data and processes, but also on the type of system an institution has in place to accommodate capital and liquidity risk factors.

In addition, institutions should assess whether they are examining the right data – such as in the case of expected credit loss (ECL) calculations done in March 2020 based on IFRS 9 requirements. While those calculations may have been done with the best intention for creating a forward-looking model, the calculations were in fact based on data that had a three-to-six-month lag. Thus, it may be more apt to do analytic calculations for stress testing scenarios based on more topical indicators, such as equity prices and anticipated frequency of default.

To be adaptable in this way, institutions will need to have systems that are so robust that even when they try to ‘break’ their own stress testing processes, any possible weaknesses will be apparent and readily fixable. Many factors contribute to creating a truly unbreakable system including:

  • Effective risk management
  • Adequate infrastructure investment
  • Right-sized human capital
  • Flexible technology architecture

The result of good preparation is that firms will not be caught off guard if an unpredictable force strikes – like an evil swan sorcerer – and that such a force won’t leave them drowning in feathers.

Balancing Known Unknowns
In a quickly changing world where unknown challenges inevitably lurk around the corner, organizations must have systems in place that will optimize resources and minimize risks. The year 2020 and Covid-19’s unpredictable effects have caused many organizations to increase stress testing runs from once or twice per year to once per week. And even this has seemed grossly inadequate at times.

Regulation expansion including Basel IV and Capital Requirements Regulation 2 (CRR2), and new regulations such Investment Firms Regulation (IFR), is feeding organizations’
anxiety in terms of assessing capital reserves, and monitoring liquidity and operational risk. And while certain known unknowns may include the central counterparty (CCP) conundrum and the corporate debt mountain, no one can predict what will cause the next crisis with 100% accuracy.

Even if an organization could have planned perfectly for Covid-19, taking such a risk averse stance could have brought business to a virtual standstill. This is a dangerous scenario that creates systemic risk and a situation that could be worse than handling Odile. There is an art to balancing the known unknowns.

Other Economic, Social, and Regulatory Considerations – Dancing Away From Basic Steps And Into Unpredictable Future Choreography

Covid-19 has shown that markets and the economy became very volatile very quickly, and a sit and wait approach may no longer be a viable solution for anyone hoping to survive the next crisis. To prepare their evolving stress testing scenarios for future shocks, organizations must take a moment to assess how they have done in the current crisis. It is safe to say that gone are the days of one rigid model that fits all types of organizations and all sorts of scenarios. Rather, institutions must be ready to enter a brave new world of unpredictability, more like an avant-garde modern dance and less like a highly codified classical ballet.

It is also important to look further than 2021, at both the five-year horizon and well beyond it taking into consideration factors like the United Nations’ development goals, other global frameworks, and associated risks including the following:

  1. There will be a cost and capital impact for incorporating emerging risks and accommodating environment, social, and governance (ESG) mandates. Are these risks in and of themselves, or are they categorized under credit/market risk?
  2. Do we have trained manpower and/or systems to understand and dimension these new risks?
  3. How can our models accommodate long-term scenarios including natural disasters, retirement liabilities, population demographics, environmental weaknesses, and black swan events that appear on a frequent basis?

It seems that no organization will be insulated from having to confront these issues. We are all being forced to handle global shocks; no event is isolated to just one part of the globe or one industry anymore. The phenomenon of internationalism brings with it a certain safety and spreading of risk, but also means more exposure for every corner of the globe and all organizations. Ideally, digitalization technology will enable increased functionality while decreasing the resources required to effectively manage these risks and grow business.

AxiomSL’s Capabilities Take The Stage

At the beginning of this blog we asked:
How can organizations fine tune their capital-liquidity-risk systems and processes to more flexibly accommodate flocks of swans and not just isolated fly-ins?
On its ControllerView® single platform for data management, analytics, and reporting, AxiomSL provides a holistic framework and seamless workflow process that enable organizations to manage capital-liquidity-risk challenges, foresee the impacts of evolving stress testing scenarios, and make appropriate, data-driven decisions. As illustrated here through the lens of its liquidity ecosystem, the liquidity stress testing and forecasting framework is integral to the overall capital-liquidity-risk architecture.

On the same platform where firms can manage high volumes of data for end-to-end calculations and reporting, they can also incorporate data and calculations into a framework that includes scenario definition, scenario application, and dashboards for regulatory and internal scenario analysis and management.

For example, to apply liquidity stress testing scenarios utilizing the stress definition and applicator functionalities, firms can automate the extraction baseline data sets iteratively with the solution’s data dictionary to build stressed data sets for the scenarios they define, as shown in the below diagram. All of this can be done leveraging a simple user interface built on ControllerView’s powerful data management capabilities. By feeding this revised data into standardized solutions including the platform’s LCR and capital calculation modules or other bespoke analytics engines, they can quickly and efficiently view stressed result sets alongside baselines and other stress scenarios. This enables organizations to efficiently comply with their ILAAP and ICAAP requirements as well.

We explore the ballet of liquidity risk stress testing scenarios and why big data is good, but ‘small’ data is better

With access to AxiomSL’s integrated stress testing capabilities, senior management gains both bird’s eye and granular views of their organizations’ capital-liquidity-risk management that they can leverage in 2021. Regardless of what type and how many swans arrive, they will be better prepared.

What Happens At The End Of Swan Lake?

When he wrote his famous Swan Lake ballet in the 19th century, Piotr Tchaikovsky offered two different endings – effectively providing two different dramatic scenarios for directors to choose from based on the ‘risk appetites’ of their audiences. However, knowing which real life stress scenarios to choose may not be determined by financial institutions, but rather by the swans themselves.

As we all move into a brave new world of evolving stress testing scenarios, decisions made now will contribute to building future-proofed processes and enhancing business growth. Financial institutions that can leverage robust data, risk, and regulatory reporting processes to meet Basel requirements – including ICAAP/ILAAP – are more resilient in times of crisis. This kind of resilience includes managing both the current crisis and any future ornithological unknowns.

To learn more about capital-liquidity-risk evolving stress testing scenarios, check out our full series: Strengthening Stress Testing Processes In 2021 And Beyond: Is The Sun Setting On 2020’s Black Swan Event Or Should We Expect An Incoming Flock?


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