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With all the news that Bernanke is a quant, I had a look at a paper presented in 2005 with data from 2003 titled Stress Testing Housing Loan Portfolios: A Regulatory Case Study:

Against the backdrop of sharply rising house prices and Central Bank warnings that housing credit growth was not sustainable, the Australian Prudential Regulation Authority (APRA) conducted a “stress test” to gauge the resilience of 120 Australian banks, building societies and credit unions to a substantial correction in the housing market. The stress test scenario mapped a 30 per cent fall in house prices to a substantial increase in default and loss rates. The results showed that all 120 institutions would remain solvent under the imposed conditions, however 11 institutions’ capital ratios fell below their regulatory minima. This paper details the stress testing methodology and traces through the various stages of the project, from background research, to stress test design, implementation, supervisory follow-up, public dissemination of the results and resulting policy changes.

The regulators are no more perfect than the credit rating agencies; models can always be improved; averages don’t mean much if you’re investing at the margins; and the world is always changing. But it is through such constant study and disaster simulation that the world is a much less exciting place than the newspapers would have us believe.

Update, 2007-10-23: It is interesting to note reports that:

Standard & Poor’s may cut the credit ratings of 207 Australian and New Zealand residential mortgage- backed securities while it examines the creditworthiness of the insurer of the underlying home loans.

S&P said Oct. 19 it may lower the credit rating of PMI Group Inc., and its Australian unit PMI Mortgage Insurance Ltd., after the second-largest U.S. mortgage insurer posted a $350 million third-quarter loss because of rising defaults on U.S. home loans.

… in light of section 7.2 of the report:

Given the heavy reliance of some ADIs on mortgage insurance, a logical extension of the project was to examine the resilience of the mortgage insurance industry to a similar stress scenario. The result of applying the stress test on LMIs revealed that LMIs would not fare as well as ADIs should the modelled stress event occur, and secondly that APRA’s minimum capital requirement for LMIs was inadequate. After more than two years of work to refine the LMI capital framework, a revised model was issued in February 2005 and is planned to come into effect on October 1 2005. Following the findings of the stress test and subsequent research and industry consultation, the proposed capital framework resulted in roughly a doubling of the minimum capital requirement and a far more risk sensitive model (with the key risk drivers being LVR, loan seasoning and loan type).

We shall see how it all works out!

Update, 2008-5-23: This exercise was discussed at a Bank of Canada conference reported in the Spring, 2008, Review. Interestingly, the author observed:

Conversely, having banks undertake the exercise themselves provided a number of valuable insights, particularly into the way banks run their businesses and how they think about the risks they manage.

For those institutions where stress testing is an integral part of their risk management framework, the stress test scenario formed the basis for a discussion of the effect of the event on individual business units and the linkages across businesses. Some banks, for example, reacted to the weaker domestic growth and large depreciation in the exchange rate by assuming a shift of resources from business units which focussed primarily on domestically oriented industries, such as service industries, and the household sector, to those that were more export oriented. For these banks, the stress test was a useful means of communicating senior management’s risk appetite across the various levels of the firm (with the results being signed off by the Board of one bank). These banks were more likely to use a mix of quantitative and judgemental assessments.

This echoes the main observation of the International Report on Risk Management Supervision … the firms that have done best (least badly?) during the Credit Crunch are the ones in which communication between departments is most efficient.

This entry was posted on Thursday, September 13th, 2007 at 12:40 pm and is filed under Interesting External Papers. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.