Risk Weighted
When narrative scenarios first became a standard tool for risk management, around the time of SCAP in 2009, I was frankly skeptical that the technique would last. Having emerged from academia, I was used to more rigorous methods and had spent years coding up very detailed and complex Monte Carlo experiments. I always thought that simulation methods, aided by advances in computing power, would eventually replace narrative scenarios for stress testing.
Consider a new pandemic scenario. In 2023, a pathogen will be discovered that, relative to COVID-19, is twice as deadly and five times as transmissible. It quickly becomes clear that vaccine development will be much more difficult than it was in 2020. Scientists estimate that 40% effectiveness is the best we can hope for, and that it will take at least three years to reach this level of development.
Honestly, this isn’t worthy of deep thought.
The COVID-19 saga has caused real difficulties for risk modelers. Loss projections made using pre-pandemic models soared in mid-2020, as global economic data spiraled downward. Portfolio performance, however, has held up very well under extremely difficult circumstances.
2020 has been a challenging year for risk modelers, rife with uncertainty. What have we learned about the effectiveness of existing stress tests and the scenarios that drive them?
In 2020, for the first time in 11 years, a U.S. stress test was conducted while the economy was actually in recession. The test has been criticized by detractors who have argued that it did not take full account of COVID-19 scenarios and therefore should have been postponed. But are these concerns valid?
Last year, the US Congress and President Trump enacted major revisions to the Dodd-Frank Act that dramatically reduced the scope of stress-testing regulations. Now, with the Comprehensive Capital Analysis and Review (CCAR)/Dodd-Frank Act Stress Test (DFAST) season in full swing for the first time since the changes, it is a good occasion to step back and assess the health of the stress testing firmament.
Society benefits greatly from bank stress testing. However, stress testing also costs society a bundle.
We can have a vigorous debate about whether the societal benefits outweigh the costs. I think they do, by a margin, but I will understand if we disagree on this point.
Risk Weighted 