Particularly in the US, with the advent of CCAR, best practices are emerging, and the US regulators are leading the way in providing most details on expectations of financial institutions. With the focus on stress testing increasing in other geographies, primarily Europe, and other financial sectors, there is an opportunity for non-US and US non-bank financial institutions to learn from the experiences of the CCAR banks to date.
There is not yet a one size fits all approach to stress testing of operational losses under different macroeconomic conditions. However, to satisfy emerging regulatory expectations and ensure appropriate stress testing results, financial institutions have been using a well-structured approach to link operational losses to macroeconomic conditions in order to develop credible results.
In this report, we explore the typical process to follow when conducting operational risk stress testing, which involves two complementary parts and several sub-steps:
1. Capturing relationships between operational losses and macroeconomic conditions
- Conducting preliminary analysis based on event types
- Projecting legal and non-legal losses using appropriate model form
- Ensuring appropriate treatment of recoveries
2. Assessing reasonableness of observed relationships
- Addressing lack of macroeconomic relationships to ensure appropriate operational loss forecasts
- Using alternative approaches such as scenario analysis
- Conducting supportive analysis
Ramy Farha, Principal
Tom Ivell, Partner
Evan Sekeris, Partner