Which of the following statements are true:

Which of the following statements are true:

I. Stress testing, if exhaustive, can replace traditional risk management tools such as value-at-risk (VaR)

II. Stress tests can be particularly useful in identifying risks with new products

III. Stress testing is distinct from a bank’s ICAAP carried out periodically

IV. Stress testing is a powerful communication tool that can convey risks to decisionmakers in an organization
A . I, II and III
B . I and III
C . II and IV
D . All of the above

View Answer

Answer: C

Explanation:

Stress testing provides an independent and complementary perspective to other risk management tools such as value-at-risk and economic capital. Both are tools that serve similar purposes but are not interchangeable. Stress testing, no matter how exhaustively done, can not replace other tools such as those based on analytical or historical models. It can provide a useful sense check to validate models and assumptions, but is not a replacement for traditional techniques. Therefore statement I is false.

Stress testing can certainly help identify risks with new products for which historical data may be limited, and analytical models may be based upon many unproven assumptions. It can help challenge the risk characteristics of new products where stress situations have not been observed in the past. Therefore statement II is correct.

ICAAP stands for the ‘internal capital adequacy assessment process’ performed by a bank (remember the acronym and its expansion). Stress testing is an integral part of a firm’s ICAAP, and not distinct. It is one of the elements of the internal process. Therefore statement III is false.

Statement IV is correct as stress testing is indeed a powerful tool that can communicate risks throughout the organization as the stress scenarios are easier to comprehend than arcane statistical models. They are also easier to explain to regulators, and are a powerful communication tool.

Thus Choice ‘c’ is the correct answer.