The additional insights of stress scenarios
Delta Lloyd Bank asked Zanders to build a stress test model
In order to assess their risk management practices, the Dutch Central Bank (DNB) requires all banks to complete an annual Supervisory Review and Evaluation Process (SREP), including capital and liquidity management self-assessments. To calculate the effect of specific stress test scenarios on the balance sheet and profitability, Delta Lloyd Bank asked Zanders to build a stress test model.
Delta Lloyd Bank is the only bank within the Delta Lloyd Group with a business model which offers mortgages and attracts savings. With a balance sheet of approximately € 5 billion, the bank is a relatively small player in the Dutch banking arena. Delta Lloyd Bank operates in the ever-changing legal and regulatory environment and there is a clear interest to consistently demonstrate how a bank can maintain compliance over the next few years.
Balance sheet projection tool
Delta Lloyd Bank has an asset liability management (ALM) tool which maps out expected mortgage and savings flows. The bank sees how much interest income mortgages generate over a certain time period and when they will be paid back. “We can forecast this for years ahead”, says Andries Broekhuijsen, Teamleader Financial Risk with Delta Lloyd Bank. “Mortgages are calculated at contract level and by using our ALM tool we can also decide if we will grant new mortgages. You get a projection of how the balance sheet will develop. In conjunction with the Business Control department you can calculate a P&L (profit and loss account) for the next five years.”
“We have developed an environment where you can see which assumption or development satisfies which regulatory requirement”
Broekhuijsen adds that the bank then goes a step further. “We have capital ratios, liquidity ratios and several other requirements stemming from the regulatory body. On the basis of the P&L and balance developments we can plot these over time. We have developed an environment where you can see which assumption or development satisfies which regulatory requirement. Also where you don’t comply, and how you can do something about it. For us, within the company, this has become a well-structured process which we use every quarter to forecast one or more years – standard balance sheet forecasting. In the balance sheet projection tool it was not possible to work out different macro-economic scenarios.”
Delta Lloyd Bank wanted to add stress tests to the tool and asked Zanders to help. “The balance sheet projection tool formed the basis for the stress test model which Zanders developed,” Koen Vogels, Actuarial Analyst with Delta Lloyd Bank explains. “There is a sort of extra layer added to the existing tool so when we input certain developments the impact of different scenarios are then presented up clearly and comprehensibly.” Macro-economic developments, like interest rate increases, a drop in house prices or a rise in unemployment, after all, affect the value of the bank’s investments. Vogels: “We needed the insight afforded by the stress tests; what happens with this projection and what are the sensitive issues? Which ratios, for example, change within a certain scenario?”
“We needed the insight given by the stress tests; which ratios, for example, change within a certain scenario?”
The balance sheet forecast made by the bank assumes a stable economic situation. “We don’t have an economic office which takes a structural view of economic developments”, Broekhuijsen says. “For our ALM we assume that most economic variables remain constant. In some cases that is not realistic. Using the report Zanders produced, we have been able to develop a number of scenarios based on various economic developments. Unemployment and house prices are very important for us as a mortgage lender. House prices determine how much security we have, while high unemployment can increase the chance of people not being able to pay back their mortgage. Picturing such developments gives us greater insight in our risk profile. We have a relatively high number of NHG mortgages (mortgages which fall under the National Mortgage Guarantee, ed.) and it appears that even if house prices drop substantially we run relatively low risk.”
A more dynamic risk situation
Even though Delta Lloyd Bank has several years of experience carrying out stress tests, they saw room to improve accuracy and efficiency. “How certain macro- economic variables impact relevant risk factors and then the balance sheet is set out in the stress test model. In that way an estimate can be made as to the outcome of the capital and liquidity ratios in specific market circumstances,” says consultant Steyn Verhoeven, who, on behalf of Zanders, helped develop the model. “The model translates certain developments in unemployment figures for example, as an effect on the possibility of payment default by clients. The balance sheet projection tool previously only highlighted one basic scenario, while the stress test model can cover various macro-economic scenarios.
“The stress test model provides the bank with a much wider and more dynamic risk picture”
This provides the bank with a much wider and more dynamic risk picture. Stress tests not only quantify a minimal capital supply, they instigate discussion on how to deal with negative developments, Verhoeven thinks: “Results from a stress test give management valuable insight into the risk profile of the bank. Which conditions should they be paying the most attention to and what means do they have to turn the tide?”
Scenarios and new assumptions
How do you determine exactly the scenarios you want to understand? Broekhuijsen: “Our basis was the stress test from the EBA (European Banking Authority, ed) and from that we refined the number of scenarios. There is, for example, a ‘baseline scenario’, which is a positive scenario that assumes an increase in house prices. We don’t just look at how bad it can get, but also at improvement.” The problem with developing scenarios is that they have to have enough stress but also tell a useful story, Verhoeven says. “You can make a scenario as extreme as you like, but it does not necessarily furnish the most valuable insights.
When developing the stress test model we deliberately opted to work out several scenarios with different stress levels.” A second challenge is the so-called second level effect of a scenario, Broekhuijsen adds. “Take rising interest rates. This results in repricing mortgages; after a certain time the fixed interest period comes to an end and the mortgage rate goes up. But this could also mean that people will want to pay back their mortgage more quickly, because otherwise their costs will increase too much. We have not taken that sort of interactive effect into account, and this is a point needs improvement.”
Reverse stress tests
Over the past few years, regulators have put more focus on stress tests. “Stress tests identify the circumstances when business as usual is no longer enough to keep your organization from dangerous territory”, Broekhuijsen explains. “But if all goes well, this only happens in very extreme circumstances.” As well as a sensitivity analysis and the scenario analysis, many banks carry out reverse stress testing. “You use this to make a recovery plan for a near default, in which you evaluate whether you have taken enough measures to be able to recover.
“Regulators have put more focus on stress tests”
You reason backwards; you determine the ratio of capital unlikely to recover and then investigate which development could cause this to happen. It could be that the credit risk when house prices drop is much lower than the interest rate risk resulting from a drop in interest. Each risk has a different impact”, according to Broekhuijsen.
With the aid of the stress test model, Delta Lloyd Bank produces a comprehensive stress test report in a short period of time. Broekhuijsen: “It comprises 15 pages with 5 scenarios and sometimes 20 sensitivity analyses. That is a complete package which we run as soon as we have the quarterly update of our strategic plan. We can show all the issues. The Asset and Liability Commission (ALCO) uses the information to determine if the planned ratio is not too low or too high. That again has an impact on our strategy.” The stress test model also enables the bank to anticipate new regulations.
“It is a complex subject,” says Broekhuijsen. “Because there are so many demands made on banks by legal and regulatory bodies, it is difficult to develop a long-term strategy which fulfills these demands. It is therefore very important that we have this tool. We can add all new regulations to the tool and as a result change our strategy; therefore scenarios are restricted to everything which is actually possible and on that basis we can decide on our selection. For example, from IFRS 9, prognoses are more relevant. Elements from the stress test environment are also requested by the regulatory bodies.”
Broekhuijsen is happy with the result and the teamwork. “Even the user interface which Zanders built was an eye opener; it is extremely user friendly. We had very little insight and now we have a great starting point. You can do a sensitivity analysis very quickly by using one single variable from the various scenarios in the stress test. We also have other points we can develop, but our emphasis is now on further integration of the stress tests. At the same time we are trying to make the risk picture more dynamic and more interactive.”