Stress Testing for Risk Control Under Basel II

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ISBN: 9780750683050 | 0750683058
Cover: Hardcover
Copyright: 12/20/2006

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Stress testing has been an essential feature of risk modelling for the last seven years. Recent Basel II developments have changed the landscape of regulatory capital, and further promoted the need for testing. As a prominent requirement, stress testing is now coming under Pillar 2; which is the responsibility of national banking supervisors - a vast market. Dimitris N. Chorafas explains in clear language the stress testing methodology necessary for risk control to meet both Basel II requirements, as well as the risks hidden behind outliers and extreme events. Written for professionals in financial services with responsibility for IT and risk measurement, management, and modelling, this book explains the nuts and bolts of new advanced testing methodology, and provides a complete account of all aspects of stress testing. Book jacket.

Preface	p. xi
Warning	p. xv
Stress testing defined	p. 1
The need for advanced testing methodology	p. 3
Introduction	p. 3
Risk distributions and extreme events	p. 3
Model uncertainty in simulation and testing	p. 6
Stress testing and the need for transparency	p. 8
Stress testing and confidence intervals	p. 11
Advanced testing methodology for better governance	p. 15
An introduction to the role of information technology in gaining competitiveness	p. 17
Risk and its management	p. 21
Introduction	p. 21
Risk defined	p. 21
Risk associated with the counterparty	p. 24
Market risk and its variants	p. 27
Risk appetite and risk aversion	p. 30
Systemic risk and event risk	p. 34
Developing a system for risk management	p. 36
The dynamics of stress testing	p. 40
Introduction	p. 40
Stress testing defined	p. 40
Advanced testing and new financial instruments	p. 43
What is the benefit of stress testing?	p. 45
Scenarios, sensitivity analysis and statistical inference	p. 48
Capital at risk under extreme conditions: an example	p. 50
Stress testing and the devil's advocate	p. 53
Advice on implementing the stress test	p. 56
Stress analysis and its tools	p. 60
Introduction	p. 60
The need for a scientific approach	p. 60
Science and the scientific method	p. 63
Fundamentals of stress analysis	p. 66
Case studies with scenario analysis	p. 69
Using the Delphi method	p. 71
Stress evaluation through sensitivity analysis	p. 74
Fundamentals of statistical inference	p. 76
Worst case scenarios and drills	p. 80
Introduction	p. 80
Worst cases happen when chance meets unpreparedness	p. 80
A bird's-eye view of worst case analysis	p. 82
Impaired claims, credit risk and worst case	p. 84
Why are worst case drills important?	p. 86
A catastrophe drill undertaken by the International Monetary Fund in 2002	p. 88
The Federal Reserve's 'new bank' and the carry trade	p. 90
The nature of worst case drills is polyvalent	p. 92
Technology strategy for advanced testing	p. 97
Introduction	p. 97
Managing a successful technology effort	p. 97
Innovation and survival of the fittest	p. 99
A phase-shift technology strategy	p. 103
Re-engineering information technology is not an option; it is a 'must'	p. 106
Projecting and implementing an enterprise architecture	p. 109
Strategic planning should account for information technology's deliverables	p. 113
Stress testing probability of default, loss given default and exposure at default	p. 119
Models and procedures for the study of volatility patterns	p. 121
Introduction	p. 121
Volatility defined	p. 121
Keeping volatility in perspective	p. 124
Improving volatility models through heteroschedasticity	p. 128
Procedural insufficiency among financial institutions and individual investors	p. 131
Algorithmic insufficiency: a case study with value at risk	p. 132
The volatility of credit ratings: a case study with General Motors and General Motors Acceptance Corporation	p. 136
Risk estimates based on volatile probability of default	p. 140
Stress testing creditworthiness	p. 144
Introduction	p. 144
Credit risk defined	p. 144
Credit standards and default likelihood	p. 147
The discriminatory ability of power curves	p. 150
The predictive power of distance to default	p. 153
The risk of unwillingness to perform	p. 155
Case study: the stakeholders of TeleDenmark	p. 158
A lesson for stress testers: loss of creditworthiness has many fathers	p. 161
Stress probability of default	p. 165
Introduction	p. 165
Probability of default and liquidity stress testing	p. 165
Concentrations of exposure and credit risk measurement	p. 169
Probability of default and stress probability of default	p. 172
Estimating probability of default through probability of default buckets	p. 175
Errors in probability of default estimates and the role of benchmarking	p. 178
The many aspects of confidence placed on a test	p. 181
Stress loss given default and stress exposure at default	p. 185
Introduction	p. 185
Loss given default and exposure at default	p. 185
The challenge of computing stress loss given default	p. 187
Stress loss given default and ability to perform	p. 190
Stress exposure at default	p. 193
Point-in-time and through-the-cycle probability of default	p. 196
Stress testing legal risk	p. 198
Stress testing other operational risks	p. 201
Counterparty credit risk, transfer of credit risk and wrong-way risk	p. 204
Introduction	p. 204
Counterparty credit risk	p. 204
Methods for handling counterparty credit risk	p. 206
Expected positive exposure and cross-product netting	p. 208
Maturity parameters	p. 211
Credit risk mitigation: collateral and haircuts	p. 212
Credit risk mitigation: new techniques	p. 216
Double default: general and specific wrong-way risk	p. 218
Expected and unexpected losses	p. 223
Stress testing expected losses	p. 225
Introduction	p. 225
Bird's-eye view of expected and unexpected losses	p. 225
Stress testing regulatory capital requirements for expected losses	p. 228
Back to basics: do we know the reason for credit losses?	p. 231
Contribution of rating agencies to prognostication of expected losses	p. 233
How to handle expected losses from lending	p. 236
The results of the fifth Quantitative Impact Study	p. 239
Thinking about models for credit risk	p. 241
Strengths and weaknesses of credit risk models	p. 243
Analysing the reasons for unexpected losses	p. 248
Introduction	p. 248
Unexpected risks confront every enterprise	p. 248
Impact of macroeconomic developments	p. 251
Risk drivers targeted by macro stress tests	p. 254
Stress testing macroeconomic risks and opportunities	p. 256
Stress testing financial instruments: a case study with interest rates	p. 258
Stress testing for unexpected losses from business risk	p. 262
Economic capital and algorithms for stress testing unexpected losses	p. 267
Introduction	p. 267
Economic capital for credit rating and unexpected losses	p. 267
Capital beyond loan-loss provisions	p. 270
Wrong correlations magnify unexpected losses	p. 274
The missing algorithm for unexpected losses	p. 276
Qualitative scenario for unexpected losses	p. 280
The board needs tools to appreciate the value of assets	p. 282
Stress testing leveraged and volatile financial assets	p. 286
Introduction	p. 286
Hedge funds: an industry born in the 1940s	p. 286
Stress testing highly leveraged institutions	p. 288
The proliferation of hedge funds and testing their risks	p. 290
The exposure of credit institutions to highly leveraged institutions	p. 292
Supervision of highly leveraged institutions	p. 295
Highly leveraged institutions at the peak of their might: No! to regulation	p. 297
The drama unfolds: highly leveraged institutions fire the boss of the Securities and Exchange Commission	p. 300
Advanced testing provides a basis for better governance	p. 303
Introduction	p. 303
A concept for better corporate governance	p. 303
The contribution of strategic thinking	p. 305
Use of threat curves and S-curves: an example from the insurance industry	p. 307
An oil industry case study on risk factors and their background	p. 310
Pillar 2 and Pillar 3 require an enterprise-wide risk discipline	p. 314
The exercise of market discipline is a significant step in supervision	p. 316
Use of stress testing by central banks and regulators, for better governance reasons	p. 318
Index	p. 322
Table of Contents provided by Ingram. All Rights Reserved.

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