Top Down Stress Testing for Bank Financial Statements: A Case Study

Case study available here.

More information on the software used in the study here.

This note shows through a case study how Risk Control’s Stress ControllerTM software may be used to implement top down stress testing of a bank. The calculations are based on the publicly available financial statement and Pillar 3 disclosures of a large UK bank.

We show how the balance sheet, P&L and key financial ratios are affected by scenarios involving recessions in America, Europe and the UK. A set of equations is constructed to describe the evolution of the bank’s financial statements.

Changes in the credit quality of the bank’s loan book and fluctuations in the value of mark-to-market exposures affect asset values and income through provisions and mark-to-market asset write-offs. For a base case and for each of the stress scenarios, predictions are supplied for the bank’s key variables.

The results show how the bank’s impairment provisions rise, and capital, asset growth, returns on equity and profitability are depressed by the different recession scenarios. A UK-based recession has a larger impact than the other recession scenarios but shows a more rapid recovery.

Note that the framework used here may be used either with coarse, public data to perform top down stress testing or with highly granular internal bank data for bottom-up stress testing purposes. The financial statement modeling is highly flexible since equations may be written first in Excel, converted into scripts and then imported into the software for use at run-time to perform calculations.