Article Tony Hughes

The current process for ensuring that banks have enough capital to cover their potential losses is too reliant on conditional scenario analysis. Replacing flawed baseline scenarios with unconditional scenarios would enable validation and hold banks more accountable for their portfolio forecasting, ultimately resulting in better stress tests.

Over the last 15 years, every stress testing issue that has cropped up has prompted precisely the same response from regulators. Scenario analysis is apparently the right tool for the job – from climate risk to concerns about bank liquidity, from questions about capital adequacy to the calculation of loan loss reserves.

However, under the current setup, the validation of scenarios is next to impossible.

While we can assess the underlying stress-testing models indirectly, by pretending that they are destined for use in structural analysis or for developing baseline forecasts, we can't directly assess the scenario projections for accuracy. The paths described by regulators never precisely occur and, even if we get a close approximation, we will still lack the repeat experiments required to demonstrate consistent performance.

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