Financial risks should receive special attention in times of financial turmoil: OSFI guidelines on stress testing

A number of financial risks — including collateral use, securitization and counterparty credit risks — have proven to require specific attention in light of the recent market turmoil, the Office of the Superintendent of Financial Institutions says in its recently posted guidelines on stress-testing.
Guideline E-18 sets out OSFI’s expectations related to the use of stress testing by all federally regulated financial institutions.
OSFI has proposed that financial institutions follow the guidelines “as soon as practicable.” 
The guideline reflects OSFI’s assessment of improvements needed for DCAT (reports to inform senior managers of risk) and stress testing in insurance companies generally.
The guidelines outline five areas that should receive greater scrutiny in stress testing in light of the market conditions that led to a global recession.
Under the heading of risk mitigation, OSFI says “the performance of risk mitigating techniques, like reinsurance, hedging, netting and the use of collateral, should be challenged and assessed systematically under stressed conditions, when markets may not be fully functioning and multiple institutions simultaneously could be pursuing similar risk mitigating strategies.”
Companies should also make sure their stress-testing covers complex and customized products such as securitized exposures.
“The stress-testing program should cover pipeline and warehousing risks,” the regulator says. “These are market, credit and funding risks arising in the period prior to securitization or sale, and which may arise from the need to hold assets for longer periods than originally planned when markets are disrupted.”
An institution should also enhance its stress testing methodologies to capture the effect of risks to reputation, OSFI says.
Counterparty credit risk should also be examined. This is when “an institution may have large gross exposures to leveraged counterparties, including hedge funds, financial guarantors, investment banks and derivatives counterparties that may be particularly exposed to specific asset types and market movements,” OSFI says.
In addition, stress testing should consider risk concentrations resulting directly from risk-taking activities, as well as those resulting indirectly from actions to mitigate risks.
The full bulletin can be accessed on OSFI’s Web site at:
http://www.osfi-bsif.gc.ca/osfi/index_e.aspx?ArticleID=3414