Value at Risk (VaR) Measuring potential changes in market values of traded assets over a short time horizon (e.g. overnight) A measure of financial market risk. Used to monitor risk profile relative to tolerance. Cash Flow at Risk (CFaR) and other Causal at Risk Models Measuring potential changes in earnings or cash flows for the enterprise. Enterprise wide measure of risk to financial objectives. Used to monitor risk profile relative to tolerance on earnings and cash flow objectives. Economic Capital Measuring the potential changes in the enterprise value from all material risks that have a financial consequences. Shareholder focus. Enterprise wide measure of risk to financial objectives that uses the outputs of VaR and CFaR. Can be used for risk criteria, pricing for risk, performance and remuneration.
17 Scenario analysis defined § Scenario analysis entails defining one or more business scenarios with associated key assumptions (sources of uncertainty termed “drivers”) that determine the severity of the consequences on a key objective. § Scenario analysis provides a single “point” estimate for the key objective and not a range of outcomes. § If the scenario has no estimate of likelihood of occurring then usually it cannot be used to estimate a risk level, unless the appetite is to be never breached under any scenario, in which case it would signal an excessive current risk profile. This is the logic for “stress test” scenarios. § Advantages of scenario analysis are: – Historically observed scenarios (eg. GFC or competitor action) can be replayed through the organisation’s risk profile and the impact can be compared with the organisation’s actual history. – It is easily understood by non-quantitative management and stakeholders. – Useful to test reliance to events. – Suitable for comparing relative riskiness across different firms for the same scenario (eg. Regulatory stress tests).
18 Illustration of scenario analysis (refer COSO)
19 Example:- APRA 2017 regulatory stress test background § Like most bank regulators, APRA utilises stress tests to examine the resilience of the largest banks, individually and collectively. § In 2017, APRA conducted an industry stress test by requesting 13 of the largest banks to estimate the impact of the following scenario. Each bank was required run the scenario through their balance sheet and calculate resultant capital adequacy ratios. ü A significant downturn in the housing market triggered by a downturn in China and a collapse in demand for commodities. ü The subsequent downgrade in sovereign and bank debt ratings leads to a temporary closure of offshore funding markets, a sell-off in the Australian dollar and widening in credit spreads. ü Australian GDP falls by 4 per cent, unemployment doubles to 11 per cent and house prices decline by 35 per cent nationally over three years.
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