by Mark Stockley, Managing Director and Head of International Cash Sales, BlackRock
The term ‘stress test’ can be applied to many scenarios where managing risk is critical – assessing cardiac health, evaluating structural stability in buildings or measuring the financial strength of banks. Depending on its application, stress testing can be quite simple and focused on measuring the impact of one key factor or variable, or it may be very complex, combining the effects of multiple influences or factors on an underlying subject.
Today stress testing has become an integral component of global banking regulators’ assessment of the strength of the broad financial services industry as well as that of individual banks. One of the most notable applications in recent years took place in mid-2009, shortly after the height of the 2007-2009 credit crisis, when the Federal Reserve conducted stress tests of the leading US banks to assess their levels of capital and ability to withstand further shocks in the economy. Fast forward to mid-2011 and European Union regulators are planning to conduct a range of tests to understand the capital strength of the major European banks.
While stress testing has proved important and topical for the global banking industry, it has also increased in visibility and importance for the global money market funds industry. However, for many of the world’s leading asset managers stress testing is not a new concept and has been an established practice within the risk management framework supporting their money market funds for some time.
What has changed is the more recent requirement from regulators and industry groups for stress testing to be a key feature of the risk-monitoring framework maintained for a money market fund by its investment adviser. For European-based international liquidity funds, the Institutional Money Market Funds Association (IMMFA) maintains a self-regulatory Code of Practice which among other recommended best practices suggests that member firms undertake regular stress testing of their portfolios. Within changes introduced in 2010 to rule 2a-7 under the Investment Company Act of 1940, the legal framework governing US-registered money market funds, the US Securities and Exchange Commission has mandated that money market funds adopt procedures to provide for periodic stress testing of their portfolios and reporting to the funds’ boards of directors on the results of such testing.