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Could Stress Testing Transparency Avoid the “Next Black Swan”? And, given the cost, is it worth it?

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One question on the forefront of every Financial Risk Manager's mind is: What will the next crisis be, and how can I help inoculate my firm against this risk?

To avoid such catastrophic events as have been seen in the recent past, regulators globally are both mandating banks to increase the rigor in their stress and also assuming the responsibility of defining the stress testing processes including continual communications, limitations, design and disclosing results directly to the larger public. The intent of such disclosure is to harmonize internal stress testing approaches, encourage banking practices accountability, reduce systemic risk and resolve system-wide market failures.

But do these stress testing disclosure measures lead to any stronger risk mitigation?

Venetia Woo, Wilfrid Xoual, Bharat Chelluboina, Jos Heuvelman and Vincent Lucanie, global risk executives from the Class of 2013 evaluated this question in their capstone project - a group project that works as a practical application of the curriculum taught throughout the year and presented at the culmination of the program.

Over the year-long project, the team conducted both a qualitative and quantitative analysis including in-depth literature review, interviews with regulators, analyst and senior executives from banks and an extensive analysis on the market returns related to the disclosures results. In conjunction with their research, “Input from our classmates, professors and Capstone advisers proved to be an extremely valuable resource to the success of our project,” Vincent shares.

Ultimately, their research illustrated that transparency in stress testing leads to improvements in systemic risk and measurable effects of market discipline. Their Capstone culminated with recommendations to regulators in defining the stress testing and disclosure standards, industry analysts in how to intake and evaluate the disclosure results and financial institutions on how to improve their internal risk frameworks. Wilfrid Xoual shares his insights on the capstone results. “The financial crisis made clear that Tax Payers could not be seen as the solution of last resort for failing financial institutions anymore. Our project, although in a very limited way, showed that it could be beneficial to provide a better visibility on risks taken by banks, and therefore allow for an earlier and cheaper solution shaping in case of problems, potentially protecting all us from the “Too big to fail” syndrome.”

The team's experience with the capstone project and overall program has impacted them both professionally and personally. Bharat shares "The MSRM program couldn't have been at a better time for me. It provided me with valuable resources and understanding which helped me effectively implement some key regulatory programs at RBS.”

Currently, their findings are in the process of academic publications and have been a source of reference in their everyday executive roles. Furthermore, the global risk community and advantages as Stern alumni continue to benefit students much further than the program. Vincent Lucanie shares, “As a Managing Director in a risk area, I have used both my academic and global classmate network in the day-to-day execution of my responsibilities. When a systemic risk issue arises, it has been invaluable network for me to reach out to bring these unique perspectives back to the workplace. The MSRM program is a perfect example of the type of training senior managers need to ensure their business is meeting this objective while remaining profit focused but not just profit centered.” Also, Venetia Woo notes, “The Capstone project is immensely relevant, several fellow alumni have contacted me on CCAR and stress testing as new regulatory requirements emerge for their institutions.”