2023 will go down as a seminal 12 months for risk managers. Recent history has presented markets with a string of crises – from the initial impact of the pandemic to Archegos and the Russia-Ukraine war – each ratcheting up pressure and shaping risk teams’ approach to markets. This year has cemented an environment driven by persistent inflation, higher rates for longer, and geopolitical uncertainty, placing risk managers in the eye of the storm.
The result is that previously once-in-a-generation risk events can now occur several times a year. This increasing cadence and intensity of crises are regularly lighting up the dashboards of risk managers. Increasingly unpredictable, complicated risks require solutions to monitor potentially dangerous exposures and pre-empt future risks.
Risk teams have been tasked with guiding firms through some of the toughest market conditions in recent memory. Fortunately, the evolving conditions have been matched by leaps in stress testing that have enabled risk teams to stay a step ahead and game possible scenarios. Without the ability to assess and respond to exposures across asset classes in real-time, 2023 could have uprooted a far greater number of financial institutions.
Past, present, and future
This has been the year of the risk manager, yet as investment firms begin to breathe a collective sigh of relief as we near year-end, the specter of a heightened risk environment remains. Stress testing has always been an important pillar of risk management, historically a tool of regulators and central banks to test the resilience of institutions to the limits. However, increasingly powerful and cost-effective technology has not only brought the technology within reach of the many but has also extended its capabilities far beyond what has historically been possible – vastly increasing the scope of tests and the speed at which they can be executed.
Following the collapse of Silicon Valley Bank over two days in March of this year, RiskSmart clients ran 15 billion stress tests on the platform. At the time, fear of contagion gripped the market as participants rushed to check that they were not exposed to banks that seemed to be teetering on the brink of collapse. Seemingly small exposures risked being magnified in the heat of crisis and consuming entire firms. Risk management teams therefore had to scramble to ensure that they were covered for worst-case scenarios – exposing any potential market or client exposure with the potential to morph into a serious threat.
Each seemingly unprecedented crisis over the past year has fed the fundamental models on which stress tests are built. Modern stress test technology consumes and uses the changing market conditions to help paint accurate pictures of potential risk – processing vast swathes of data to account for changing time horizons, changing economic conditions, and new asset classes. While stress tests present a compelling vision of the future, it is important not to lose sight of the past. Stress tests have also allowed teams to simulate past crises as certain risks lie dormant, awaiting the next cycle.
This powerful technology has handed greater power and responsibility to risk management teams. As stress testing becomes increasingly accessible, it is incumbent on risk management teams to use these capabilities effectively and creatively – leaving no stone unturned when seeking to expose potential weaknesses or gaps in resilience. These outcomes of stress tests are fed into an increasingly interconnected risk ecosystem, informing calculations around margin, value at risk (VaR), net liquidation value (NLV), and sensitivities – enabling firms to adjust their current exposures in anticipation of future risk.
No turning back
We can say with near certainty that we will see events in 2024 that will require robust risk management responses, as high rates bite and geopolitical tensions remain high. The events that rocked 2023 offer clues to how markets may respond to crises in the coming year. As firms wind down and plan for the New Year, risk managers will have to continue to be on watch for the signs of the next crisis.
The past year has demonstrated that the complexity and speed of crisis scenarios are too great for humans alone to anticipate and manage. To survive in modern markets, risk teams need to weave stress testing into their workflows.