Reverse stress testing
This comment piece examines the regulatory requirements about reverse stress testing. In it, a brief overview of three different regulatory bodies requirements is given, followed by FRSGlobal's analysis of each regulation, considering some of the likely market impacts. The comment piece concludes with how FRSGlobal‟s solutions can help firms approach the issue of reverse stress-testing.
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FSA CP08/24
At the end of 2008, as a response to the financial crisis and the liquidity crunch, the FSA released a consultation paper which introduced - for the first time - the concept of reverse stress testing. The paper set out requirements for firms to identify and assess the scenarios that are most likely to cause their current business plan to become unviable.
In this context, a firm's business plan should be assumed unviable at the point that:
- Crystallising risks cause the market to lose confidence in it,
- With the consequence that counterparties and other stakeholders are unwilling to transact with it or provide capital to the firm,
- And, where relevant, that existing counterparties may seek to terminate their contracts.
BCBS_155
The Basel Committee of Banking Supervision (BCBS) picked up the topic of reverse stress testing in its "Principles for sound stress testing practices and supervision" paper in May 2009. The paper states requirements for firms to consider scenarios beyond normal business settings which lead to events with contagion and systemic implications. Hence, reverse stress testing has important quantitative and qualitative uses, such as informing the senior management‟s assessment of vulnerabilities.
CEBS CP32
Finally, the Committee of European Banking Supervisors (CEBS) iterates the requirement in its December 2009 consultation paper for firms to identify a scenario or combination of scenarios that lead to an outcome in which the institution‟s business plan becomes unviable and the institution insolvent.
FRSGlobal comment
Risk feeds into every contract and service of a financial institution. The risk drivers are markets, counterparties and behaviour. The risks impact liquidity, income and value of a firm. Not only that the drivers are inter-related but also the outcomes.
The experience from the financial crisis shows that the impact on liquidity, income and value may lead to business failure well before a firm‟s regulatory capital is exhausted. Business failure of a firm has contagion for the group to which the firm belongs and potential systemic risk implications. The FSA (CP08/24) therefore states that: "Scenarios that may constitute business plan failure for a firm may differ from those that may constitute such failure for a group of which it is a member. Whereas the failure of a group is likely to be accompanied by the failure of a member firm, the opposite may not necessarily be true. Therefore, for a firm that is a member of a group, the reverse stress test should be carried out on a solo as well as group basis."
A key element of reverse stress testing is the risk assessment which leads to economic scenarios to be investigated under qualitative and a quantitative aspects at group and firm level in respect to liquidity and business failure i.e. in respect to liquidity, income and value.
