ADI stress testing frameworks found wanting

Over 2018-19, the Australian Prudential Regulation Authority (APRA) conduced a qualitative assessment of the internal stress testing capabilities across 28 ADIs. The scope of the assessment covered the ADIs’ most recent enterprise-wide stress tests (EWST) and the most recent internal capital adequacy assessment process (ICAAP) reports.

The focus areas for the assessment were governance, scenario development and use of stress testing.

The participants in the assessment were split into two peer groups: group one comprised larger diversified ADIs, while group two comprised other participants with total assets ranging from $3 billion to $25 billion.

According to APRA’s findings, the ADIs in group one generally had better frameworks installed within their organisations compared with those in the second group.

Governance

Most group one ADIs had EWST frameworks with formalised governance structures, clear roles and accountabilities, and documentation to support most aspects of their stress testing process.

However, the frameworks were not always subject to independent reviews.

Group two ADIs generally did not have specific frameworks for stress testing, and instead relied in part on various risk-specific management frameworks and ICAAP documentation.

“When compared to group two, group one entities typically had broader engagement across the organisation in their stress testing activities,” APRA deputy chair John Lonsdale stated in the report.

Scenario development

APRA found that most group one ADIs have structured and integrated scenario development processes that engage stakeholders across the organisation. These institutions generally considered well stress parameters and impacts, and scenarios usually covered all or most material risks identified by the entity.

However, the process at most group two ADIs tended to be less structured and integrated than those in group one, and these ADIs typically designed their scenarios and stress parameters with less sophisticated considerations.

“Participants in both groups would benefit from better coverage of non-financial and emerging risks,” Mr Lonsdale said.

“Many participants used previous APRA industry stress test scenarios either as a substitute for their own internal ICAAP scenarios, or as a reference to inform the macroeconomic settings of their own internal scenarios.”

Use of stress testing

APRA also found that group one ADIs generally made better use of stress test results and used stress testing in a wider range of decision making than those in group two.

Their ICAAP reports included details of the stress test undertaken and the implications the results had on their main capital management decisions.

Group one ADIs generally used a set of capital adequacy criteria to express their risk appetite and assess their stress test results. The specific level of detail and coverage differed across the peer group.

Stress testing played a smaller role among the group two ADIs, where ICAAP stress testing results were generally only used for the validation of their main internal capital targets.

“They typically did not have well-defined risk appetites around their capital adequacy,” Mr Lonsdale said in the report.

Stress testing to focus on climate change

The report included better practice examples across each area, while APRA provided feedback to individual ADIs that participated in the assessment on their practices, to enable them to improve their stress testing capabilities.

APRA said it intends to publish a prudential practice guide on stress testing to promote industry better practice and consistency. It will consult with the industry in the second half of 2020.

APRA also said it will increase frequency and depth of stress testing for ADIs, including transitioning in 2020 to annual stress testing of large ADIs.

“APRA also plans to test resilience to broader scenarios, including the impacts from operational and climate change financial risks,” Mr Lonsdale said.

According to APRA, its assessment was informed by the Prudential Standard APS 110 on Capital Adequacy, the Prudential Practice Guide CPG 110 on ICAAP and Supervisory Review, the 2018 Basel Committee on Banking Supervision Stress testing principles 1, and regulatory stress tests.

The stress testing assessment forms a part of APRA’s strategic priorities for 2020, specifically the regulator’s supervisory priority.

[Related: APRA outlines key strategic priorities for 2020]