Stress Testing

The Bank of England (BoE)’s Annual Concurrent Stress Test (ACS), published in September this year, identifies persistently high inflation that leads to a policy response of a higher base rate. Impacts include high unemployment, a significant house price index/commercial real estate (HPI/CRE) decrease, and material gross domestic product (GDP) decreases across the world’s developed economies. This material uncertainty has brought stress testing to the top of the agenda for many chief risk officers (CROs).

The primary concern raised by the network was the lack of representative data for modelling inflationary impacts. The scenario of persistently high inflation, unemployment and interest rates is unprecedented and would have material impacts to everyone, but particularly to borrowers with low income and limited financial resilience.

The stress scenario is also now partially reflective of current UK economic conditions. Rates are higher, with some participants suggesting they were stressing at levels well above the BoE’s defined benchmark. There are already affordability impacts as fixed rate agreements mature. Firms had even seen customers requesting to end fixed rate contracts early to re-fix at the higher rate, in anticipation of future BoE rises. This introduces new and complex conduct issues that risk functions must consider.

Past government Covid-19 interventions also caused the CROs concern. There is a consensus that the true impact of current conditions has been delayed, both in terms of company insolvencies and through the savings households made during the restrictions in 2020 and 2021. As this starts to unwind, there is an expectation of an increase in arrears and defaults. Furthermore, the group predicts that customers are likely to be more forthcoming in requesting forbearance following the mandated access to payment holidays during 2020.

Model risk

The Prudential Regulation Authority (PRA) released a consultation paper on model risk management (CP6/22) in June 2022, setting expectations for lenders to improve their understanding and control of model risk.

CROs shared their concerns on the appropriate holder of the Senior Management Function (SMF). As model risk management is considered a first line of defence function, the most obvious candidate (the CRO) may not be suitable. The growth in scope, due to broadening model definitions, was another concern for smaller firms, with a large increase in the number of models captured in each firm’s inventory.

Resourcing requirements for independent model validation (IMV) and internal audit was highlighted as a significant challenge. There was a perceived limited pool of suitably skilled and independent staff willing to perform IMV full time. Internal Audit functions were also lacking the requisite experience and capacity to include the new model risk management requirements.

Finally, the expectation that models developed and maintained by third parties (e.g., credit reference and climate risk models and data) should be validated to the same standard as internal models appeared very challenging. Third party firms were unwilling to provide all the necessary information and code (due to concerns over intellectual property) to allow this to be done inhouse and meet lenders’ model risk appetites. Indeed, the largest lenders have already been challenged on this by the PRA and expect the scrutiny to increase with the application of the forthcoming supervisory statement.

For in-depth information on how you can prepare for the upcoming model risk regulations, read Carl’s latest blog on Jaywing’s website.