By  Babajide Komolafe
The President of Risk Managers Association of Nigeria (RIMAN), Dr. Emmanuel Abolo, has said stress testing, which is used to determine the stability of a given system or entity by testing beyond normal operational capacity in order to observe the results, should be made a regulatory requirement in Nigeria.

Speaking on Stress testing: Where the banks got it wrong and the way forward, at the recently concluded RIMAN confe-rence in Lagos, Abolo said stress testing in the banking industry involves the analytical process involved in subjecting a bank’s portfolio to a series of battery of tests, designed to study the performance of the bank’s portfolio under extreme adverse conditions to generate the potential risk measures under plausible events in abnormal markets.

“Stress testing is not an end unto itself as results have to be used in the risk management process. Results should be carefully considered when setting risk limits.

“Stress testing must be relevant to the bank, its balance sheet and the business environment and it must be severe enough to reveal ‘tail’ risk exposure (i.e. improbable risk) without being completely improbable. Stress testing must be detailed enough to reveal vulnerabilities.”

It will be recalled that last month, the Committee of European Banking Super-visors conducted a European Union-wide banking stress test exercise.

The stress test was mandated by the Council of the European Union (in its economic and financial – ECOFIN – configuration) in the aftermath of the global financial crisis which started in 2007.

The second of its kind, the exercise assesses the financial strength of European banks under different adverse scenarios. This was done in cooperation with the European Central Bank, the European Commission and the national supervisory authorities of the member states. Of the 91 banks tested, 7 failed the 6 % tier 1 capital ratio threshold: 5 in Spain, one in Germany, and one in Greece.
On where banks got it wrong with stress testing in the past, Abolo stated “Most stress tests were simple sensitivity analysis – not stressful enough- and an adoption of too narrow a definition of plausibility. Extreme  events are unprecedented and  involve a concatenation of events that seems implausible before it happens.

Stress tests were not conducted regularly (i.e. ad-hoc) which made it impossible to understand changes in the risk profile or vulnerabilities of the institution. Hence, new sources of surprises passed by. The results of stress tests were rarely discussed and did not form part of the risk management architecture.

“Stress tests were conducted in silos and not integrated in a forward-looking manner. Definitions of scenarios and methodologies used to stress test vary across sections of the portfolio and entire organization.

“Inter-bank contagion tests not conducted: impacts of contagion in the inter-bank market, i.e. sensitivity of a bank to inter-bank contagion risk. Stress tests were carried out as a stand alone exercise for the purpose of  show-off; results rarely used in risk management and capital planning decisions.