Stress testing with scenarios is in vogue. The Financial Times reported that European banking regulators plan to introduce a tougher stress test process as part of a new mechanism to force recapitalizations of banks. How useful is the tool for pension funds?
The stress test basically forms a scenario, in which the bank is confronted with generally unfavorable conditions. For a bank, that amounts to a combination of drying up of liquidity, increased volatility combined with declining share prices, sovereign risk on the rise, economy close to a halt, increasing the bankruptcies and dropping house prices, and lowering the collateral value behind the mortgages. If banks and regulators concur that the scenario is extreme but not impossible, the bank then calculates with this scenario how much capital and reserves are eroded. If this is below a threshold, additional funding is required- and calm and quiet are restored on the financial markets.
Pension funds increasingly use scenarios too for their own stress testing. Risk managers have their work cut out, since there are enough examples around to base scenarios on. Japanese deflation, the 2008-9 financial crises, stagflation in the 1970s or less extreme, a more modest repeat of the boom cycle of the 1990’s. Risk managers feed the assumptions in their models, and create extensive tables in which the projected financial health of the pension fund in a base scenario is compared with the other scenarios.
Scenarios and stress tests do good work. They raise awareness about the uncertainty of the outcomes in financial markets, and allow trustees to make informed decisions about which outcomes are detrimental to participants, while they might be avoided in an early stage. The usefulness of scenarios is, on the other hand, somewhat limited when funds struggle to turn this concept into an effective instrument in their strategic toolbox.
For example, what if trustees or advisors cannot resist the temptation to attach more weight to one scenario than another, usually to the one that most resembles the current situation? The outcome of the discussion then is: we should compliment ourselves with our positioning of the portfolio right now.
Scenarios and stress tests probably do their work if trustees can get a feeling for the magnitude if they make the “wrong” decisions. What if the fund is fully committed to a deflation scenario and raises its interest rate to 100%, while inflation suddenly emerges? This should help create awareness that focusing on predicting a scenario is dangerous, let alone fully basing the fund’s strategy on one.
The missing link in working with scenarios and stress however is decision-making and communication. A scenario unfolds over a longer period. While trustees might have all the information about the scenario at hand, the neat tables with percentages do not prepare them for an extreme situation. Trustees should not work with abstract figures alone, but should be trained to cope with real live situations (especially the bad ones). What will your actions be when the cover ratio is 150% – 105% – 90%? How will stakeholders react? Will you still rebalance or not? These are the kind of situations trustees should get familiar with. This type of training will help a fund cope with future crises, and is especially helpful in an unstable environment where the time span between the occurrence of financial and economic crises continually decreases. Split up the discussion about scenarios in several events, and give trustees homework: what would you do now? What would you communicate? After the discussion, the next phase in the scenario is then presented, helping trustees to think about what they would actually do. Preparation and training is no news for large funds with dynamic ALM, but an innovation for smaller funds. We expect firemen and ambulances to practice regularly for unexpected situations, so why not the trustees to whom I have delegated the task of providing for my income once I am 65, the prospective pensioner could justifiably ask.
 Bar to be raised for EU bank stress test, Patrick Jenkins and Brooke Masters, Financial Times, March 6 2011