Policy
Response
BSA response to FSA consultation on stress and scenario testing, CP 08/24
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Contact: Andrea Jeffries Date: 31 Mar 2009 |
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Background
1. The Building Societies Association represents all 53 building societies in the United Kingdom. Building societies have total assets of £395 billion and, together with their subsidiaries, hold residential mortgages of £250 billion, more than 20% of the total outstanding in the UK. Societies hold over £235 billion of retail deposits, accounting for more than 20% of all such deposits in the UK. Building societies also account for about 37% of all cash ISA balances. Building societies employ over 51,500 full and part-time staff and operate through more than 2,000 branches.
Introduction
2. We are conscious of the large volume of substantive consultation and discussion papers published by the FSA recently. Economic and political conditions do require FSA to review many of its policies, but we consider that the sheer volume of policy documents is causing serious overload to our members at the moment. Building societies rightly focus on running their businesses and therefore have limited time to read these documents in depth, or to compare the different proposals to check for possible duplication and/or inconsistency.
3. We do acknowledge the FSA’s efforts to allow greater scrutiny of papers by adding a little extra to the consultative period, as it has done with this consultation on stress and scenario testing. But we consider that this is not enough. Better would be sector-specific proposals with longer deadlines.
4. Some societies even question whether these papers represent meaningful consultations, or merely advance warnings of the FSA's decisions. It does appear sometimes that little real attention is paid to substantive comments.
5. In our response, we have drawn heavily from drafts prepared by the joint trade associations – BBA, LIBA and ISDA. Many of the points these associations make echo concerns raised by building societies.
FSA consultation on stress and scenario testing: FSA 08/24
Response on consultation by BBA, ISDA and LIBA
General
6. We believe stress testing should be applied to those firms that have a material impact on market stability and in a manner that is proportionate to their systemic significance. Any regulatory approach should take account of that. But it should be remembered that stress testing is just a tool, not an exact science. To make it meaningful, sound judgement rather than metrics is needed.
7. We agree that stress and scenario testing supports the identification, assessment and management of risk. Furthermore, it is an important tool for informing senior management about sensitivities in a bank’s risk profile and potential vulnerabilities in its business model. We support the FSA in its efforts to better understand industry practice in this area. Regulators do need to understand business models, including their impact on peers and the systemic risk posed by models, and the mitigating action taken by building societies and banks.
Reverse stress testing proposal
8. As signalled by the joint trade associations, there is concern that the FSA’s intentions regarding reverse stress testing are not sufficiently clear. This is a major worry of building societies. For example, we are not sure if the FSA wishes firms to identify:
i. a range of disaster scenarios eg natural disasters, major market meltdowns that could destroy the firm, or
ii. the assumptions on which the business model is based and stress these factors to the point where the model is no longer viable and counterparties lose confidence in the firm, or
iii. some form of overlap.
9. Whatever way, implementing a reverse stress testing requirement as set out in the consultation poses major challenges for building societies. There is room for a potentially infinite range of scenarios to be explored. This is not practical and the Handbook text, as currently drafted, does not provide sufficient explanation of the FSA’s requirements for firms to gauge if their interpretation of what is reasonable and achievable matches the regulator’s.
10. We agree that there is a place for examining extreme scenarios which explore the potential failure of a firm’s business model. Regulators need to be realistic, however, about the possible limited and marginal impact that the process will have in influencing strategic and business planning, and helping the development of robust contingency plans.
11. The trade associations suggest that the emphasis of any reverse stress test requirement should be on a qualitative assessment of potential vulnerabilities in business models and how these could be appropriately managed. They believe that attempting to identify the point at which market confidence is lost in a reverse stress test scenario and any capital implications depends more on qualitative assessments and careful judgements, although quantitative inputs help assess the impact. We agree.
12. Building societies have also been very worried that the reverse stress test will lead to an automatic increase in a firm’s minimum capital requirement. But we understand from an FSA meeting with trade associations on 22 January that this is not necessarily so. Nonetheless we would appreciate official confirmation of this.
13. The reverse stress requirements will lead to higher costs, causing further strain to building societies already under stress from recent market downturns. We consider that reverse stress tests may not be appropriate for those societies not of systemic importance.
Scenario selection
14. Like the trade associations, we agree that firms should operate a range of scenarios of different types and severities, but acknowledge that there will only ever be a limited number appropriate to each firm. There are potentially a great number of scenarios that could be run by firms with infinite outcomes. A balance is required, therefore, between maximising coverage, the costs involved and the capacity for senior management to integrate the resulting information into high level decision making. We therefore endorse the trade associations’ suggestion of allowing firms to develop their scenario testing over a number of years in order to arrive naturally at the optimum level.
15. We also agree that Pillar 2 stress testing should focus on realistic and plausible scenarios which are more likely to resonate with senior management. These could be supplemented by a limited amount of testing based on low probability scenarios, including reverse stress testing.
16. It is important that FSA should to strike the right balance between prescription and guidance when setting any industry-wide common scenarios. Scenarios generally need to be firm specific to ensure effective deployment of resources and appropriate use of senior management time. Where the FSA prescribes common scenarios, it should provide adequate notice, sufficient opportunity for industry consultation (a minimum of three months) and sufficient implementation time to facilitate robust and reliable results.
17. The FSA needs to give careful consideration to the requirements proposed in other papers currently under consultation, for example the new liquidity regime, CP 08/22, for example, the third scenario of the individual liquidity adequacy standards. Parallel, perhaps overlapping, requirements make it difficult for firms to react if they are unable to take a holistic view, especially when making necessary consequential system changes. We would like explicit confirmation in future consultations that the FSA has taken these other requirements into consideration.
Impact on individual capital guidance
18. Building societies, like members of the joint trade associations, are unclear as to how the proposed changes to the stress testing requirements will fit into the supervisory review process, including how the results will be used in setting individual capital guidance. In the original guidance for the inclusion of stress testing under Pillar 2 / ICAAP, the FSA stated that where it judged that a firm did not have sufficient capital, they would require a capital add-on. It would therefore be useful if the FSA clarified the interaction of Pillar 1 and Pillar 2, and how the original ICAAP stress testing and the proposed reverse stress testing are expected to operate together.
19. We have, however, been reassured by the January meeting with trade associations where the FSA officials did say that adverse results from stress tests in general would not automatically lead to capital add-ons. Nonetheless, we would appreciate official confirmation. We would also like the FSA to clarify how it would compare one institution with another.
Role of management
20. The role of the board of directors and senior management in stress testing is important. Boards have ultimate responsibility for the approval of their firms’ ICAAPs and stress tests. But how firms implement these will be based on their own individual governance processes. Regulators need to recognise that while boards are responsible for oversight of the risk management function, they must be allowed to delegate some of that responsibility to relevant senior management, or to suitable committees.
21. As the joint trade associations have pointed out, risk managers can use this consultation as an opportunity to obtain greater senior management buy-in, increase the visibility of risk management and promote a more risk-aware culture across their firms. Equally, this is an opportunity for supervisors to understand better firms’ business models and their impact on other firms.
Responses to individual questions in the consultation paper
We have attempted to answer those questions that have the most significance to building societies.
Q3: Do you consider our reverse-stress testing proposal reasonable?
As said earlier, we believe that reverse stress testing has to be carried out on a qualitative, rather than purely quantitative basis to be useful. This is because the point at which a building society (or bank’s) operations become unviable is hard to define. In addition to the capital position measures, the building society or bank’s business plans may become unviable due to liquidity constraints; either when the wholesale funding sources dry up, or when the retail depositors lose faith and there is a run. The reputational aspect is impossible to quantify with any degree of accuracy.
As the trade associations have also pointed out, there must be full clarity on how the results of the reverse stress test will be used in setting a firm’s individual capital guidance.
Reverse stress testing will have an impact on firms’ costs, causing further burden in a time of stress. We believe that these requirements may not be appropriate for those firms that are not systemically important. These firms could be granted a waiver.
Q7: Do you agree with our proposed clarification of the use of stress testing for credit risk mitigation purposes?
We also think that such stress testing should only be necessary if the risks arising from credit risk mitigation are considered by the firm to be material and are not already covered by other assessments. The main stress testing rule, GENPRU 1.2.42, requires stress testing of residual risk where that risk is considered to be a "major" risk. Further clarification would be helpful if FSA now intend that firms should go further than this.
Q8: Do you agree with our perception of the role of stress testing in operational risk and our proposal not to prescribe any additional stress testing requirements specifically for operational risk?
We agree with the proposal not to prescribe additional stress testing requirements for operational risk.
Q9: Do you have any comments on the proposed changes to the general stress and scenario testing rule and additional guidance for firms?
As stated elsewhere and by the joint associations, we would like to see a limited, manageable range of scenarios. And as they have also pointed out, these scenarios should consider adverse events in the future and not be a re-run of the current economic conditions.
Q10: Do you have any comments on our requirements that in general firms should hold capital now against the overall financial adequacy rule, including in a stress scenario after allowing for realistic management actions?
As stated earlier, building societies would appreciate official clarification on changes to individual capital guidance. Like the trade associations, we do not believe building societies (or banks) should hold capital in order to sustain all conceivable loss scenarios. We also agree with them that the FSA should be more specific as to the severity of stress for which the overall financial adequacy rules needs to be met.
