“You can model your risk to be anything you want it to be.” That’s a pretty popular saying among modeling skeptics. They recognize with “forward-looking” stress-tests there is a real danger of manipulating the results based on what you think will happen in the future. Loan and deposit growth, new product pricing, or changes in balance sheet mix may all be changes you expect to happen in the future but…what if they don’t? Given that we’re generally pretty bad at predicting the future it’s prudent to run a stress-test that assumes your balance sheet mix and volume will remain pretty much the same.
Question from the FAQ:
8) When no growth scenarios for measuring earnings simulations are mentioned, can you clarify what no growth means?
Answer from the FAQ:
“No growth” refers to maintaining a stable balance sheet (both size and mix) throughout the modeling horizon. Financial regulators are concerned that including asset growth in model inputs can reduce the amount of IRR identified in model outputs. For example, if model inputs predict significant loan growth occurring after a rate shock, new loans are often assumed to be made at higher interest rates. This has the effect of reducing the level of IRR identified by the model. If this assumed growth does not occur, the model would underreport actual IRR exposure.Institutions should recognize and understand how growth affects model output. Management should run scenarios that maintain the balance sheet constant across the simulation horizon. These types of scenarios help highlight the current level of risk in the institution’s positions without the effects of growth assumptions. As a sound practice, management could contrast the “no growth” scenario with scenarios that include growth assumptions to highlight how future growth may change the institution’s risk profile.
This no-growth scenario is sometimes also referred to as a “static” forecast. This is in contrast to a forecast that might include some sort of growth which is often referred to as a “dynamic” forecast. The original IRR advisory addressed the difference between the two. Back in September I offered further clarification:
Most people…assume that static means “no-growth” and dynamic means “growth”…That’s almost right. It is generally accepted that static means “no-growth” or a constant balance sheet. But dynamic doesn’t necessarily mean “growth”. It really means “changes” in the balance sheet.
What’s the difference between a static versus a dynamic forecast? | Sept 2011
