On Stress Testing & Pillar II Risk Measurement

CEYLON TODAY | Published: 2:00 AM Apr 8 2021

Ernst and Young in Sri Lanka (EY), successfully carried out an informative half-day training session for all Licensed Commercial Banks (LCBs) and Licensed Specialised Banks (LSBs) on Integrated Stress Testing during Pandemic and Pillar II Risk Measurement.

The event was attended by many participants from banks including Chief Risk Officers, Finance Managers, Risk Managers, Compliance Managers and other individuals involved in Internal Capital Assessment Adequacy Process (ICAAP) from Finance and Risk teams. Timely response of EY team to a pertinent matter impacting LCBs & LSBs was highly commended by the participants. The discussion included the importance of integrated approach to stress testing incorporating pandemic impact and Pillar II Risk assessment and measurement.

Rajith Perera, Partner - Financial Accounting Advisory Services of Ernst and Young, Sri Lanka facilitated the workshop. He shared his insights on challenges confronted by financial services sector when assessing regulatory capital post pandemic era for ICAAP submission. The session also covered areas such as assessment and measurement of Pillar II risks such as Liquidity Risk, Cybersecurity Risk and Reputational Risk including future developments which could carry a substantial impact to the financial services sector.

During his opening remarks for the session, Rajith stated, “Even though the larger exposure to stress on capital is due to Pillar I risks (minimum regulatory capital for credit and market and operational risk) financial institutions cannot underestimate the effects of the Pillar II risks (such as Liquidity Risk, Reputational Risk, Cyber Risk & etc.) which could intensify due to the adverse impacts of the Pandemic. As a result, banks may not be able to rely on traditional stress testing and risk measurement techniques (locally and globally) resulting from economic slowdowns and pressures.”This led to the discussion of the importance of having a scientific approach to stress testing and sound risk management framework for Pillar II Risks.

Discussion highlighted the common weaknesses seen in current practices of financial services such as stressing risks in isolation, limiting stress testing to sensitivity analysis, not considering the impact of macro-economic variables, lack of rationale for application of stress testing methodologies. To make Stress Testing relevant in current context,it was recommended to use unprecedented conditions resulting from COVID -19 pandemic scenario into Stress Testing. Further, it was emphasised that Modelling methodologies adopted by Banks should capture behaviour of macroeconomic variables along with hypothetical scenario definition and selection of macroeconomic factors based on balance sheet structure and risk profile of a bank. Rajith reiterated “stress testing should be dynamic and forward looking – i.e. factor-in business growth plans, structural shifts in funding profile, and capital strategies”. Conceptual Model for Market Risk and Scientific Methodology for Operational Risk Stress Testing was demonstrated to participants.

Further during the session, he covered how Banks could integrate Value at Risk (VaR) models to measure market risk exposures, He went on to elaborate that institutions owning VaR Systems have failed to integrate the output to ICAAP. Rajith was specific on the validation requirements of the VaR models prior to deployment as it can result in generating inconsistent loss exposures. Further, during the session Rajith demonstrated how an institution could develop Parametric/Non-Parametric VaR models and demonstrated the VaR,a Tool developed by the Financial Services Risk Management team of EY in Sri Lanka which has the capability to measure VaR exposures to Equity Instruments, Fixed Income Instruments & Derivative Instruments to aid measurement of Market Risk.

Towards the latter part of the session Rajith turned the attention of the participants to identification, measurement and assessment of Pillar II risks. He stated “Risk management best practices are at the heart of Pillar II; Quantification of risks has become a more significant aspect of Pillar II, especially during the post-pandemic and  Banks must undertake an ICAAP that looks at all risks to which the bank is exposed”. This led to a lively discussion on understanding risks such as Cybersecurity Risk and Reputational Risk. Here the benefits financial institutions can get by moving into a scoring-based approach to assess internal capital requirements was brought to light.

CEYLON TODAY | Published: 2:00 AM Apr 8 2021

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