Stress tests and their importance for Solvency

🎓 Recently Mark mentioned an interesting thesis topic “how to destroy shareholder value”, which was successfully defended at Nyenrode Business University. Many of us were probably wondering if a thesis topic “how to create shareholder value” was more beneficial.

🚦 However, the next day I saw a strong article about famous SVB bank bankruptcy story, where you could read in very details how it managed to reach that point. A big US bank, 40 years of experience, embraced by Silicon Valley with all possible technologies. And it immediately became obvious: it’s important to know how to not only create the value but also how to destroy one (in order to avoid the last one). That’s how a classical risk management science was born.

👓 I will not go into details of how SVB has managed to achieve such an unexpected milestone (you could probably read about it in the well written article below). The key conclusions are the following ones:

🛡️ 1) Stress tests

Often the risk managers are focused on classical Value-at-Risk (VaR) ratio calculations, which give with certain confidence/probability an exact amount that the possible losses should not exceed. However, the market regulators often base their requirements on more prosaic and straight forward stress tests. Many people might think that the stress tests don’t make much sense, because they are based on unrealistic stress sizes and it’s better to use a classical “more realistic” VaR modeling. A truth is that you have to use both. Whereas VaR will give you an expected limit for losses, the stress tests could provide you with the entire picture of the balance and P/L figures in case a defined stress happens. Yes, there is no big chance that tomorrow the interest rates change dramatically, however, apparently even 50-75 bps quarterly change may accumulate to a substantial amount over a period of time depending on your balance sheet structure. A secret is that when you build a stress test – build it realistically. What is realism in a stress test? It’s a gradualness. There is a famous saying that changes accumulate gradually but are realized suddenly. The same principle is applied to every area of life: whether it’s success or failure – there is always time to recognize a pattern. Of course, if you have specialists who can recognize, understand and solve such patterns.

🤖 2) Digitalization

As you could read in the mentioned article, a problem with HTM (Hold-till-Maturity) portfolio decline (due increased interest rates) in fact happened last September. As HTM portfolios are reported at amortized costs rather than mark-to-market ones – CEO continued to enjoy a cycling…🚴

💡 Next week I will tell you about stress tests, which SVB was supposed to have and which could safe its solvency.

☕ And for now – enjoy a weekend, and of course, a good article

#svbcollapse #riskmanagement #stresstesting #Valueatriskmodels #solvency