By Eze Nwagbaraji

The most convoluted and perhaps most abused phrases in our financial and banking circles today are “Stress Test” and “Risk Assessment.”

Financial, market, and monetary policy operatives in mangled quests for regulatory validations superimpose these phrases across our market and economic terrains as if they are cure all for economic validity and regularity certainty.

Bankers and financial market operatives complain of the dearth of qualified risk assessment professionals and the Central Bank of Nigeria used stress test assessment as the trigger with which the financial sector and perhaps the economy to date, was dealt its most devastating regulatory blow in our economic history.

The most cardinal principle of any free market system remain that private operatives engage the market in pursuit of profits while government regulatory and self-regulating (operating with express permission from the government) institutions, serve as unbiased umpires. When governments participate in the market, they must play by accepted rules, if market integrity must be sustained.

An additional and fundamental truism of free markets is the existence of market cycles, which are the well known cyclical and periodic movements in market sentiments and modes, driven by investors and participants’ perceptions of what market conditions are. In other words, markets go up and markets go down. In either condition, market participants remain in the market.

The role of policy is to balance the realities by providing level of assurances borne out of competence. Anything else may leave the market with its private participants with injuries that may take generations to heal. This is because significant sources of private funds invested in public markets are earned over generations by those who have chosen thrift over current consumptions.
UNDERSTANDING RISK ASSESSMENTS

Risk Assessment as used by investors, business managers, and bankers, is the process of determining the likelihood that a specific or particular negative event will occur. Armed with this statistical probability, the decision maker attempts to undertake a particular venture or investment fully aware of the inherent risks in the event of a particular loss.

Risks in markets can come from uncertainty in financial markets, project failures, legal liabilities, credit risk, accidents, natural causes, disasters, and indeed regulatory inertia and gross incompetence as well as deliberate attacks from an adversary.

Several risk management standards exist in business and finance universe because some of the risks faced by institutions and operatives in the market may be multiple in nature and may not be amenable to a single or one directional solution.

Effective risk management strategies must include sound value judgment and will certainly include transferring the risk to another party, avoiding the risk, reducing the negative effect of the risk, accepting some or all of the consequences of a particular risk, and creating a risk value system where certain risks are aggregated and pooled for operational core knowledge and skill acquisitions within the institutional environment.

Portfolio and fund managers traditionally use Conditional Value at Risk (cVaR) to gauge and reduce the risks associated with the potential of incurring large losses to their portfolios. Mortgage lenders in competitive and properly regulated markets use Loan-to-Value Ratios to evaluate the risks associated with lending funds to purchase a particular property in particular neighborhoods, regions, markets, etc.

Bankers and other financial institutions use Credit Analysis to gauge a potential borrower’s financial data, ability to repay the loan, and eventually at what interest rate to lend money within regulatory guidelines.

For institutions such as banks and investment and portfolio managers, risk assessment is a step in a procedure. It is the determination of quantitative and or qualitative value of risks related to a concrete situation and a known threat. The quantitative approach calls for calculations of the Risk and the magnitude of the Loss. A third component requires estimation of the Probability that the Loss will occur.

A calculation with high probability of occurring will definitely be treated differently from one with a low probability of occurring. Risks with high and low probabilities of occurring may be given equal priority and weight theoretically, however, in practice, it is very difficult to manage when economic conditions such as scare resources, time, know how, etc. are taken into consideration.

In Finance, banking, insurance, pharmaceutical and health, aviation and transportation, energy, natural resource extractions, national security, and management of the national economy, risk assessments and efficient risk management are the hallmarks of an effective regime.

In each of these and more, efficient risk management require a prioritization process where the risks with the greatest loss and the highest probability and certainty of occurring are dealt with first, and those with lower probability and lower loss are handled in descending order.

In a competitive free market economic environment such as Nigeria, private and government market participants face the enormous task of understanding and effecting the highest and the most value oriented risk balancing act. Balancing between risks with high probability of occurrence but lower loss versus risk with high loss but lower probability of occurrence is very difficult and is susceptible to being mishandled.

When deficient knowledge is applied to a risk management situation, even risks with 100% occurrence rate can be misunderstood and ignored. These intangible risks, a failure of the ability to identify or appreciate risks, when carried out at the economy-wide macro levels morphs into a knowledge deficiency risk which may lead into ineffective collaborations across specific units at the macro levels.

The cascading consequences of these risk appreciation failures are the emergence of relationship risks and ineffective operational procedures.

In both micro and macro-economic units of our free market systems, poor relationship risks and ineffective operational procedures reduce the productivity of all knowledge workers, decrease cost effectiveness, profitability, quality of services, reputation, brand values, quality of earnings, etc.

Risk management also faces difficulties in allocating resources. This is the idea of opportunity cost. Resources spent on risk management could have been spent on more profitable activities. More than three centuries of economic thought has shown that an ideal risk management regime minimizes spending and minimizes the negative effects of risks and maximizes positive returns on invested capital.

STRESS TEST
Financial Stress Test is a technique (usually a simulation) used on assets and liabilities to determine their reactions to different financial situations.

It may also be used to measure how a specific or group of scenarios will affect a particular firm or an industry. Stress tests are usually simulation models that test hypothetical scenarios. They are hypothetical because their occurrence vitiates their importance.

From an institutional perspective, it is used to evaluate the strength or otherwise of the company or firm in question. Financial and non-financial institutions run stress tests on themselves with varying scenarios as management attempts to create simulated conditions that may enable them confront adverse and sometimes positive business issues.

Though not new, stress test acquired considerable prominence in contemporary financial lexicons following the global financial uproar that began in 2007 in the United States and moved across leading financial centers of the world, including Nigeria. In the United States, it was known as a Supervisory Capital Assessment Program, jointly initiated by the US Federal Reserve Bank (Central Bank) with tacit support from the US Treasury (The Ministry of Finance).

The American brand of stress testing was not limited to banks or financial institutions, though banks constituted significant number of companies stress tested by the regulatory institutions. It was an assessment of capital adequacy rate carried out to determine if a select number of the largest US Financial institutions or money intermediaries had sufficient capital to withstand what was seen in 2007 and 2008 as an emerging recession and financial market turmoil.

Stress testing commercial banks and bank holding companies in the United States may have been borne out of the reality that some of United States leading businesses, such as General Electric Corporation (NYSE:GE), Ford Motor Corporation (NYSE:F), Minnesota Mining and Manufacturing Company (3M) (NYSE:MMM), Proctor & Gamble Corporation (NYSE:PG), etc. have financing arms that engage in the financial market more than several banks.

The few banks that were stress tested in the United States were also those with assets in excess of US$100 billion and further primary reasons for the test was to ascertain whether the US$350 billion left from the economic bailout funds would be sufficient to cover needed funding for the banks after the test.

The test was also to ascertain the abilities of these financial institutions to withstand the worst case scenarios in the country’s and global financial crisis.

During weak or recessionary times, banks and or financial institutions may be required by regulatory authorities to pass compulsory stress tests. The concept is to enable the regulatory authorities maintain strong oversight in the financial sectors.

The process should be direct and applied even handedly. Its objective should be to measure the “what if” effect on the financial institution should the scenario become a reality. In conjunction with the target financial institution, the regulatory authorities will identify toxic assets, i.e. assets whose probative values are less than amounts loaned on them.

These assets are classified as illiquid and inflated in value and may no longer be serviceable. The examiners will segregate the loans from those that are performing according to the terms.

Taking into consideration the consequences of ill perceived policies in customer confidence on such individual banks or on the entire financial industry, the regulator may also look into such avenues as the probability of enforcing the creditor bank’s rights against the debt defaulters.

Though the inherent problem here is that the customer-banker relationship is one borne of contract and it is almost impossible for a bank to claim undue influence in its contractual relationship with a customer. If non-performing portfolios are greater than the asset base of the bank, such bank could be declared  distressed.

Once distressed, servicing and rescue mechanisms are activated to maintain the status of the institutions as a monetary policy intermediary or force such institution into receivership.

A stress test may also look at credit impairment in bank held securities such as collateralized debt instruments, uninsured mortgage backed securities, successes of regulatory oversight, etc. To be effective, financial stress testing must be forward looking, as a supervisory or regulatory mechanism, it must gain the trust and confidence of the operators of financial institutions and those within the target industry.

It must set tangible baselines that assure all market participants of its genuineness and expectations. It must never be an attempt to settle or correct past known regulatory failures. The benefits of such stress tests should never be in doubt.

Stress testing is one of the tools that can be used to measure the vulnerability of portfolios to abnormal shocks and market conditions. It is one in a menu of regulatory and policy tools that may be effectively employed by supervisory market agents. Stress testing in financial markets does not have uniform applicability across market frontiers. It is market and economy specific.

The component variables and the skill levels of regulatory agents are fundamental in any attempt to create a reasonable or effective stress test. If a stress test will result in a frozen credit market or capital hoarding, then its usefulness is questionable. Stress test in an inefficient capital market or within a failed regulatory regime is also questionable.

They are not meant to prevent a failed business concept from failing or extending a rescue kit to a comatose business contraption. The primary focus of a financial stress test is to support the macro-economy, hence its assumptions must be realistic and not endanger industry and market wide confidence.

A stress test does not correct inherent defective capital circulation and credit lending regimes. Pouring funds into existing financial institutions that have been unable to succeed in free and competitive environments does not lead to success, irrespective of the source of such funds.

Defective financial engineering formulas, irrespective of how couched and or the genuineness of those thrust with their implementation would not create the endearing successes that are required in the credit markets for sound economic growth.

The banking, finance, and investment universe of the 21st century has grown at a tremendous pace, accelerated by rapid innovations and cross border business and financial integrations. Democratic institutions, even in the West African sub-region have contributed to lower macroeconomic volatility in specific countries in the region and there are increases in cross border capital market participation. The results are the identifiable broad acceleration rates in risk dispersions through credit risk transfers.

Creating and developing a coherent framework to analyze the resilience of financial institutions and banks abilities to withstand strains and external pressures are complex and financial systems behavior in less efficient markets are difficult to model. These complexities become profound under stressed conditions.

Financial Risk Assessments and Stress Tests are subjective value based tests administered to ascertain predetermined scenarios. They are vulnerable to the adequacies and inadequacies inherent in the knowledge base of those who design such value judgments.

When used as measures to confront industry wide issues, their successes and failures will depend on their applications to real scenarios. There is no guarantee that institutions that pass risk assessments and stress tests will survive economic down turns as opposed to those who fail such tests.  Inherent in these tests are also their applicability. While the United States has proven that it can earn profits for tax payers funds invested in companies that were rescued two years ago, that scenario have not been successful in Nigeria.