Research20080900 - Fishing for complements Christopher C....

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Fishing for complements September 2008 Christopher C. Finger chris.finger@riskmetrics.com Stress testing works as a complement, rather than as a supplement, to major risk management tools such as Value- at-Risk. Though long a staple risk management practice, stress testing has received little formal discussion. An important step was the survey of stress testing practices by the Bank for International Settlements (BIS) in 2005; the quotation above is the first sen- tence of the survey’s conclusion. This is a particularly subtle use of language for a reg- ulatory document, and I imagined the writer chuck- ling as I headed to the dictionary to ascertain the precise distinction between supplement and comple- ment. There are two: first, supplement simply means to add to, while complement brings to notion of com- pleting; second, when supplement is used, it carries the connotation that the thing being supplemented is somehow deficient, while something that we com- plement is usually fine as it stands. So are stress tests truly complements—that is a com- pletion of tools that are already quite good—as the BIS survey suggests, or are they merely supplements, attempting to bolster something that is not all that great to begin with? In part, we should ask whether the “major risk man- agement tools” are of value on their own. Let us as- sume that these tools incorporate statistical risk mod- els broadly. Generally, statistical risk models incor- porate two elements: a forecast for the joint distri- bution of the future state of a (typically large) set of market factors, and a link from these market factors to a specific set of holdings. At a basic level, we use statistical risk models because there are a lot of different things that can happen to the market, and we cannot hope to assess each of the different pos- sibilities individually. We use statistical models to merge an objective view of plausible market events with our own portfolio sensitivities, and to summa- rize how bad things might get. Are today’s statistical risk models useful on their own (and in need of a complement) or deficient (and in need of a supplement)? It is easiest to find pro- ponents of the latter choice, though model defenders exist. Rather than assess these models in detail, our approach here will be to survey stress testing prac- tices, and ask what these say implicitly about our confidence in the statistical models. Last year’s model Moving to actual stress test practices, let us begin with stress tests used in implementations of risk- based capital. In these cases, a supervisory body specifies a (possibly large) set of prescriptive tests, and the party being tested is said to “pass” if its worst loss across all the tests is less than a predetermined c ± 2008 RiskMetrics Group, Inc. All Rights Reserved.
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threshold. Examples here are ratings for certain structured products, regulatory control for banks in some markets and margin limits for some exchanges. This notion of stress testing is in fact neither a sup-
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Research20080900 - Fishing for complements Christopher C....

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