Risk Forum Panel Session on Stress Testing : 31/03/15 Top down versus Bottom up Panel session on stress testing 8th Financial Risks International Forum Paris, March 31, Henri Fraisse, Research Directorate, ACPR

Risk Forum Panel Session on Stress Testing : 31/03/15 Bottom up vs Top down 2  Out of scope : the stress testing models used by the institutions for internal purposes (for example, budget planning)  Bottom up supervisory exercice  The supervisor provides 2-3 scenarii to the financial institutions  The institutions run some internal models and report outcomes to the supervisor  Top down supervisory exercice  The supervisor uses its own internal models to simulate the impact of the scenarii. They are based on regulatory reporting

Risk Forum Panel Session on Stress Testing : 31/03/15 Bottom up exercices pros/cons 3  Pros  A level of granularity absent from the prudential reporting and necessary to stress some components of the portfolio (market positions, funding, …).  More reactive to emerging risks : stickiniess of the prudential reporting (for example sovereign risk)  Take into account Banks’ specifics  Cons  Hidden information problem : incentives for the institutions to evade the stress tests  Interactions between these two types of exercices  Top down models as challenger models to the results provided by the institutions

Risk Forum Panel Session on Stress Testing : 31/03/15 Academic contributions :« hidden model » framework in order to improve the design of the regulatory framework 4  Colliard (2015) on the strategic choice of risk models inside the IRB approach  Harris and Raviv (2014) on how to give banks incentives to disclose bad news  Bouvard et al. (2015) : a theory of optimal transparency when banks are exposed to rollover risk 18/12/2014

Risk Forum Panel Session on Stress Testing : 31/03/15 Key elements of the EBA/ECB stress test 5  Two scenarios: baseline and adverse with a three year horizon (2014, 2015, 2016) and as a starting point  Static balance sheet assumption for the horizon of the ST  Threshold of 5,5% CET1 for the adverse scenario and 8% CET1 for the baseline  Definition of capital based on minimum transitional arrangements according to the CRR e.g  Several risks were covered : credit risk, market risk, funding, securitisation and sovereign risk 18/12/2014

Risk Forum Panel Session on Stress Testing : 31/03/15 Key elements of the EBA/ECB stress test 6  Hyprid exercice : mix of bottom up and top down exercices  Credit risk parameters benchmarks were provided  Red, amber, flag process :comply or explain on all the risks  Sign off from the banks 18/12/2014

Risk Forum Panel Session on Stress Testing : 31/03/15 How to force the banks to apply the stress with a sufficient level of severity : a practical approach 7  Second best : more severe methodology  More data collected from the banks during the ST exercice (10,000 data points in 2011 vs 30,000 data points in 2014)  Benchmarks across time (projected credit risk parameters)  Benchmarks across banks (competitors, market discipline)  More intrusive top down models based on more granular data (new prudential reporting, European credit register)  Regulatory review in order to improve the quality of the stress test models developped by the banks to respond to supervisory stress tests 18/12/2014

Risk Forum Panel Session on Stress Testing : 31/03/15 Tentative definitions of bottom up 8  Taxynomy to be discussed in international fora (EBA, BIS)  Definition #1 : which entity is in charge and has the legal right to access the data?  Definition #2 : anything beyond the scope of the available top down models  Definition #3 : who is in charge of translating the macro scenario to the institution’s risk parameter and in fine computing the solvency ratio ?