Capital Planning, Stress Testing and Risk Quantification
Capital planning
Capital planning links risk appetite and the business plan to capital needs over a multi-year horizon. Distinguish regulatory capital (Pillar 1 minimums plus buffers - CET1 4.5%, Tier 1 6%, total capital 8%, plus conservation, countercyclical and G-SIB/D-SIB buffers) from economic capital (an internal estimate of unexpected loss at a chosen confidence level) and from available capital. ICAAP evidences adequacy; recovery and resolution planning address what happens when it is not.
Stress testing
Steps: define scenarios (base, adverse, severely adverse, or a firm-specific narrative), translate macro variables into P&L, balance sheet and capital, then govern results through credible challenge and use in decisions. Reverse stress testing starts from the point of business-model failure and works backwards to the scenario that causes it - it identifies vulnerability, not probability.
Quantification
VaR, Expected Shortfall, Monte Carlo simulation, sensitivity analysis, RAROC and risk-adjusted pricing allocate capital to exposures. RAROC = risk-adjusted return ÷ economic capital.
Traps
- Treating stress testing as a compliance exercise rather than a management tool.
- Confusing reverse stress testing with a severe-but-plausible scenario.
- Assuming regulatory capital equals economic capital.
- Forgetting contingency actions and management buffers.
Rule of thumb: a stress result is only useful if it names the actions it would trigger - dividend restriction, deleveraging, hedging or capital raise - and the threshold at which each is invoked.