Institutional Investors' Stress Testing Will be Beefed Up

by Robin Pilgrim, LawAndTax-News.com, London

18 December 2009

A survey by MSCI Barra found that stress testing was a critical risk tool in the aftermath of the 2008 crisis needed at the enterprise level to manage potential large market disruptions. At the same time the UK's Financial Services Authority (FSA) is toughening up on its stress testing requirements.

To produce "The Future of Market Risk Management," one of the most in-depth surveys of institutional investors' current and future risk management practices, MSCI Barra interviewed over 30 of the world’s largest pension plans and asset managers with combined assets under management of over USD4 trillion.

While 73% of pension plans and 26% of asset managers surveyed do not currently run stress tests, the majority said they would focus on stress testing in the future, recognizing this as the critical component for integrating qualitative and quantitative information, enterprise risk management and liquidity and counterparty risk analysis. One asset manager acknowledged that stress testing should be like "crash-testing for cars."

Other key findings included:

• Less than one-fifth of corporate pension plans surveyed have a Chief Risk Officer function, compared to 80% of surveyed public plans and 70% of surveyed asset managers.
• Only 40% of asset managers and 18% of pension funds surveyed run stress tests by shocking factors within a factor model. The most common stress tests were macroeconomic shocks (including shocks to currencies, commodities, interest rates, etc.) and market-wide asset class shocks.
• Though all asset managers surveyed invest in multiple asset classes, only a few use the same risk model across asset classes.
• The majority of respondents surveyed called for enterprise-wide risk management tools across all asset classes.
• Currently, private real estate, timber, foreign bonds, hedge funds, convertible bonds, structured products, certain derivatives and asset-backed securities are the key assets that survey participants indicated are generally not covered by their risk systems. All pension plans surveyed intend to add coverage for hedge funds, private equity real estate and private equity. As one pension fund put it: “If all private equity commitments were called at the same time, we would have to significantly reduce our global public equity investment.”

The following views were consistent amongst all participants:

• The impact of liquidity events must be better understood.
• Funding liquidity issues such as capital calls and redemptions need to be better assessed.
• Market liquidity issues such as the pricing of illiquid assets need to be assessed.
• Institutions should have some limits on counterparty risk.
• Risk across the organization should be assessed – which requires a consistent framework across all investments and products.

The FSA will soon require UK firms to introduce a "robust and effective stress testing program" to assess their ability to meet capital and liquidity requirements in stressed conditions. As part of its more intrusive supervisory approach, the FSA runs its own stress tests on a periodic basis, mainly for specific high impact firms, to assess their ability to meet minimum specified capital levels throughout a stress period.

The FSA will be recommending scenarios to help improve capital planning in 2010. Firms subject to the new reverse stress testing requirement will have 12 months to incorporate reverse stress testing into their current suite of stress tests and risk management tools.

The FSA has published a short consultation paper clarifying its approach to capital planning buffers (CPB). The CPB is the amount of capital held to absorb losses and meet higher capital requirements in adverse external circumstances such as an economic downturn.

The FSA is consulting on simplifying its approach and has provided further clarity about expectations on the use of the CPB and the mechanism by which firms can draw down the buffer. The consultation period closes on March 31, 2010.

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