Reverse Stress Testing

Reverse Stress Testing

Tool to improve business planning and risk management

 

The new reverse testing guidelines for BIPRU firms is outlined in the FSA Policy Statement 09/20 (Stress and Scenario Testing). The reverse stress testing is in addition to the existing Capital stress testing (conducted as part of the ICAAP exercise) and the Liquidity Stress testing (as per PS09/16).

FSA’s overall integrated stress testing framework is as shown in the diagram below

FSA Stress testing framework

(Diagram Copyright Financial Services Authority (FSA))

The purpose of the reverse stress-test is to identify and consider scenarios that would lead to a firm’s business model becoming unviable. The primary use of reverse stress-testing is as a risk management tool to improve business planning and risk management rather than to inform decisions on appropriate levels of capital or liquidity specifically.

Reverse stress testing starts from an outcome (i.e., failure of the business) and identifies circumstances in which this may occur, rather than testing for outcomes arising from changes in circumstances of different likelihoods.

Risk appetite and reverse stress testing

Reverse stress-testing is designed to identify issues, such as risk concentrations, that may affect the alignment of a firm’s business strategy and its risk appetite, by requiring the firm to consider scenarios that would cause its business model to fail. In undertaking reverse stress-testing, each firm should consider and document the interaction between business failure and its stated risk appetite. (Ref: Page 16 of policy statement)

Proportionality in reverse stress-testing

For smaller, simpler firms, reverse stress-testing may primarily be an exercise in senior management judgement focused on scenario selection. For very small firms the submission may be a short written explanation of these factors, which would simply need to be periodically refreshed. It does not necessarily involve detailed modelling. For larger, more complex firms, a more structured and comprehensive approach to reverse stress-testing is expected. (Ref: Page 18 of policy statement)

Good practice in stress and scenario testing

The key point that help in building an effective stress testing infrastructure are (based on Annex 3 of the policy statement):-

1. Board and senior management should actively engage in stress and scenario testing, taking ownership and responsibility for establishing an effective stress testing programme and infrastructure in the firm.

2. Senior management should take a key role in implementing the firm’s stress testing programme by being actively involved throughout the process, including in scenario selection.

3. Senior management should take action as a result of stress testing and integrate stress testing outputs into the firm’s decision-making process.

4. Firms should establish a stress testing programme covering all relevant levels of its business, all risk types and over a range of severities.

5. Stress and scenario testing should be undertaken on a forward-looking basis, with sufficient use of firm-wide stress testing helping firms to identify risk concentrations, assess interdependencies and understand second-order effects.

6. Firms should establish a robust stress testing infrastructure with appropriate IT systems and resources in place. The infrastructure should be periodically reviewed by senior management for its continued effectiveness.

7. Firms should have clearly documented policies and procedures to enable effective implementation and maintenance of the stress testing programme, which should be periodically reviewed by senior management.

Developing appropriate scenarios

Applying an appropriate degree of severity to stress scenarios is not sufficient in itself to ensure the effectiveness of a stress test. An effective mechanism to translate macroeconomic parameters into specific effects on a firm’s risk parameters is equally important. Nonetheless, severity is important and the definition of ‘appropriate severity’ has attracted significant debate in 2009, as expectations and understanding of a ‘severe yet plausible’ scenario took account of experience through the recent market turmoil.

Other factors to consider while choosing scenarios:-

  • addresses all material risk types and factors relevant to the institution – this mainly means credit risk, market risk, operational risk, interest rate risk and liquidity risk as appropriate, but this is not exhaustive;
  • addresses institution-specific vulnerabilities, including regional and sectoral characteristics and specific product or business-line exposures and concentrations;
  • considers a confluence of events and in particular, the possibility that a sharp market shock may be followed by a prolonged period of economic decline;
  • contains a scenario narrative that includes various trigger events where appropriate,
  • which could include monetary policy, financial sector developments or triggers, such
  • as commodity prices or even political events and natural disasters;
  • is forward-looking over the same period as the ICAS/ICAAP;
  • captures the most severe elements and probability of occurrence that an institution expects to survive – it should be a serious but not fatal scenario related to a firm’s stated risk appetite in a meaningful and consistent way and tested for resilience in relation to that risk appetite; and
  • considers dynamic feedback effects and second-order effects of Pillar 2 risks with each other.

Firms should also consider the potential impact of second-order effects in their stress testing (for example, liquidity risk resulting from operational failure of a counterparty from whom the firm was expecting funds).

The key risks that the firms have to consider are: - (GENPRU 1.2.30 R)

  1. credit risk;
  2. market risk;
  3. liquidity risk;
  4. operational risk;
  5. insurance risk;
  6. concentration risk;
  7. residual risk;
  8. securitisation risk;
  9. business risk;
  10. interest rate risk
  11. pension obligation risk ; and
  12. group risk.

Parental support

FSA takes a conservative approach in relation to guarantees or commitments of parental support as an acceptable management action in the context of capital planning and any associated capital planning buffers. Only in exceptional circumstances would FSA be prepared to consider accepting parental support as a mitigating tool or action. In those cases, the onus is on firms to demonstrate that the parental support arrangement is legally enforceable, effective, credible, and will be forthcoming in stressed conditions i.e. the parent will not itself be under such stress that it is unwilling or unable to effect the transfer of capital to its subsidiary.

Periodicity

Under normal circumstances, reverse stress testing must be conducted at least once a year. In the first instance, firms must complete the reverse stress testing exercise by the 14th of December 2010 and should also include it as part of their next ICAAP documentation.

Key extracts from the handbook

SYC 20.2 Reverse stress testing requirements

20.2.1 R As part of its business planning and risk management obligations under SYSC, a firm must reverse stress test its business plan; that is, it must carry out stress tests and scenario analyses that test its business plan to failure. To that end, the firm must:

(1) identify a range of adverse circumstances which would cause its business plan to become unviable and assess the likelihood that such events could crystallise; and

(2) where those tests reveal a risk of business failure that is unacceptably high when considered against the firm’s risk appetite or tolerance, adopt effective arrangements, processes, systems or other measures to prevent or mitigate that risk

20.2.3 R The design and results of a firm’s reverse stress test must be documented and reviewed and approved at least annually by the firm’s senior management or governing body. A firm must update its reverse stress test more frequently if it is appropriate to do so in the light of substantial changes in the market or in macroeconomic conditions.

GENPRU 1.2.42 R (2) Stress and scenario tests

In carrying out the stress tests and scenario analyses in (1), identify an appropriate range of adverse circumstances of varying nature, severity and duration relevant to its business and risk profile and consider the exposure of the firm to those circumstances, including:

(a) circumstances and events occurring over a protracted period of time;

(b) sudden and severe events, such as market shocks or other similar events; and

(c) some combination of the circumstances and events described in (a) and (b), which may include a sudden and severe market event followed by an economic recession.

GENPRU 1.2.60 R (3) Documentation of risk assessments

A firm must make a written record of the assessments, details of the stress tests and scenario analyses carried out, including any assumptions made in relation to scenario design, and the resulting financial resources estimated to be required in accordance with the general stress and scenario testing rule.

Additional reference information

1) FSA's reverse stress testing policy statement PS09/20 (Dec 2009)

2) Bank of International Settlement (BIS) - Principles of sound stress testing practices (May 2009)