Term
| Why is stress testing an important risk management tool? |
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Definition
| it enables banks to identify the potential sources of risk, evaluate the magnitude of risk, develop tolerance levels for risk and generate strategies to mitigate risk. |
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Term
| Stress testing and risk governance - describe the weaknesses identified during the financial crisis? |
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Definition
- Lack of involvement of board and senior management
- Lack of overall organisation view
- Lack of fully developed stress testing
- Lack of adequate response to crisis |
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Term
| Stress testing - what were the recomendations following the financial crisis? |
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Definition
board and senior management actively involved in stress testing
- board ultimately responsible
- senior management responsible for managing, implementing and reviewing the program
- Senior management should ensure the results of stress tests are used in decision making processes |
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Term
| What are the 4 major areas a bank's stress testing program should focus on? |
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Definition
- Risk identification and management
- Alternative risk perspectives
- Liquidity and capital management
- Communication (both internal and external) |
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Term
| Stress testing methodologies - what were the weakneses identified? |
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Definition
- Inadequate infrastructure
- Inadequate risk assessment approaches
- Inadequate recognition of interactive effects
- Inadequate firm wide perspective |
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Term
| Stress testing scenarios - weaknesses identified in crisis were...? |
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Definition
- Lack of depth and breadth
- Lack of adequate techniques
- Lack of forward looking scenarios |
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Term
| Stress testing scenarios - what were the recomendations following the crisis? |
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Definition
- cover a variety of events (both at micro and macro level)
- Futuristic outlook
- Synergy effect
- Time horizon (cover various time horizons along with liquidity conditions)
- Reverse stress testing:
3 phases (outcome, events, and hedging |
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Term
Describe weaknesses identified and recommendations for improvement in stress testing handling of :
- risks arising from the use of complex structured products |
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Definition
For structured products the credit rating for regular bonds was used to determine riskiness.... this did not hold.
Recomendations:
- A stress test should use all the relevant info about an underlying asset pool
- Impact of market conditions
- Contractual obligations
- Subordination level of a specific tranche |
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Term
Describe weaknesses identified and recommendations for improvement in stress testing handling of :
- basis risk
First off, define basis...
then basis risk...
then how can it occur...
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Definition
Basis is the difference between prices or interest rates between the cash market and the futures markets.
Basis risk: changes in basis between opening and closing of a futures position is basis risk.
Basis risk can occur due to low correlation between the price movemetn of underlying cash instrumetns and the futures contracts, cross hedging, and relative illiquidity of futures contracts.
Weakness was that banks ignored basis risk |
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Term
Describe weaknesses identified and recommendations for improvement in stress testing handling of :
- wrong way risk
what the heck is it?
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Definition
- a wrong-way risk emerges when the PD of counterparties increases as a result of general market conditions.
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