Improving Risk Management Practices through Reverse Stress Testing

A stress-test (ST) involves an analysis or simulation of different circumstances in which a financial instrument or financial firm (Firm) is exposed to pre-determined external conditions. In essence, the ST seeks to theoretically put the financial instrument or Firm ‘under stress’ in order to identify to what extent the financial Instrument or Firm can withstand such pre-determined external conditions. A firm’s business model will become unviable at the point where crystallising risks cause the market to lose confidence in the Firm, so that counterparties and other stakeholders are unwilling to transact or provide capital to the Firm.[1] Reverse stress-tests (RSTs) are complementary to STs in that they seek to identify potential areas of operational weakness that may lead to a business model becoming unviable, and the firm failing. However, they do so in reverse, by first identifying business failure outcomes and then tracing back to identify the circumstances that would lead to such outcomes. By identifying additional relevant Tail Risks[2], a Firm is not lulled into a false sense of security about its operational risk profile based on standard ST methodologies. By identifying complex scenarios which may be improbable, but not impossible, a Firm is better able to reconfigure its risk management practices to withstand extreme external events. The RST is therefore a risk management tool that allows Firms to improve risk management practices.

Basel Committee on Banking Supervision ‘Principles for sound stress testing practices and supervision’

The Basel Committee on Banking Supervision (BCBS) states that stress-testing is a tool that supplements other risk management approaches, and plays an important role in providing forward-looking assessments of risk.[3] It can help to overcome limitations of models and historical data, it can feed into capital and liquidity planning procedures, it can inform the setting of a bank’s risk tolerance, and it can help to facilitate the development of risk mitigation (or contingency plans) across a range of stressed conditions. The BCBS also notes that the recent financial crisis highlighted certain weaknesses in pre-crisis stress-testing practices. These were: (1) the use of stress-testing and integration in risk governance; (2) stress-testing methodologies; (3) scenario selection; and (4) stress-testing of specific risks and products.

The BCBS notes that the financial crisis highlighted a number of methodological weaknesses. One of these weaknesses was that pre-crisis risk management models used historical statistical relationships to assess risk. This meant that STs assumed risks were driven by known and constant statistical processes, and that historical relationships constitute a good basis for the forecasting the development of future risks.  However, the financial crisis highlighted serious flaws in this approach, as ST models did not pick up on the possibility of severe shocks (i.e. Tail Risks) nor the build up of vulnerabilities in the system. The BCBS states that extreme reactions occur rarely, carry little weight in models based on historical data, and are hard to model quantitatively. The BSBS observes that the management of most banks did not sufficiently question the limitations of more traditional risk management models used to derive stress-testing outcomes, most banks did not perform STs that took a comprehensive firm-wide perspective across different risks and books.

Moreover it was also noted that most bank STs were not designed to capture the extreme market events that were experienced. It was observed that scenarios tended to reflect mild shocks, assumed shorter durations, and underestimated the correlations between different positions, risk types and markets due to system-wide interactions and feedback effects. Stress-testing practices should therefore consider important interrelations between various factors such as: (1) price shocks for specific asset categories; (2) the drying-up of corresponding asset liquidity; (3) the possibility of significant losses damaging the bank’s financial strength; (4) growth of liquidity needs as a consequence of liquidity commitments; (5) taking on board affected assets; and (6) diminished access to secured or unsecured funding markets.

Specific risks that were not covered in sufficient detail in pre-crisis STs included; (1) the behaviour of complex structured products under stressed liquidity conditions; (2) basis risk relating to hedging strategies; (3) pipeline or securitisation risk; (4) contingent risks; and (5) funding liquidity risk. The BCBS therefore notes that an appropriate stress-testing programme should cover forward-looking scenarios to incorporate changes in portfolio compression, new information, and also emerging risk possibilities which are not covered by relying on historical risk management, or which replicate previous stress episodes. The BCBS recommends that as part of the overall stress testing programme, it is important to include some extreme scenarios which would cause the firm to be insolvent. For large complex Firms this will be a particular challenge, as it will require the involvement of senior management and will cover all material risks areas across the Firm. The BCBS recommends that a good RST should include enough diagnostic support to investigate the reasons for potential failure, and further notes:

Areas which benefit in particular from the use of reverse stress testing are business lines where traditional risk management models indicate an exceptionally good risk/return trade-off; new products and new markets which have not experienced severe strains; and exposures where there are no liquid two-way markets.[4]

SYSC 20: Reverse Stress Testing

Chapter 20, Senior Management Arrangements, Systems and Controls (SYSC 20), of the Financial Conduct Authority (FCA) Handbook sets out rules relating to RST which require a Firm to identify and assess events and circumstances that would cause its business model to become unviable. The rules stipulate that the Firm’s senior management or governing body review and approve the results of a RST exercise, which may help the Firm’s senior management to identify a Firm’s vulnerabilities, in order to design business failure risk mitigation or prevention strategies. SYSC 20.2.1 states that a Firm must RST its business plan, i.e. carry out STs and scenario analyses that test its business plan to failure. The Firm is also obligated to:

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

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

SYSC 20.2.3 states that a Firm’s RST must be documented, reviewed, and approved by the Firm’s senior management or governing body at least every year. [5] RST business plan failure occurs at the point where the market loses confidence in a Firm and the Firm is therefore no longer able to carry out its business activities, e.g. the point at which all or a substantial portion of the Firm’s counterparties seek to terminate their contracts, or a Firm’s existing shareholders are no longer willing to provide additional capital. [6] When Firms are carrying out stress tests and scenario analyses, a firm should at least take into account key sources of risk (i.e., credit, market, liquidity, operational, insurance, concentration, residual, securitisation, business, interest rate, pension obligation, and group risks).[7]

Any RST carried out should be appropriate to the nature, size and complexity of the Firm’s business and of the risks it bears.[8] Where a RST shows that a Firm’s risks of business failure is unacceptably high, the Firm is required to devise realistic measures to prevent or mitigate the risk of business failure (taking into account the time that the Firm would have to react to these events and implement those measures). Firms are required to consider if any changes to business plans are appropriate, and all measures (including changes to business plans) should be documented. When undertaking RST Firms are required to consider “scenarios in which the failure of one or more of its major counterparties or a significant market disruption arising from the failure of a major market participant, whether or not combined, would cause the firm’s business to fail.”[9]

Appropriate Regulators are authorised to request a Firm to: (1) quantify the level of financial resources which, in the view of the Firm, would place it in a situation of business failure should the identified adverse circumstances crystallise; (2) submit the design and results of its RSTs (and any subsequent updates as part of its risk assessment; and (3) implement specific measures to prevent or mitigate the risk of business failure, where that risk is not sufficiently mitigated by measures adopted by the Firm and the Firm’s potential failure poses an unacceptable risk to the Appropriate Regulator’s statutory objective.

The RST should be appropriate to the nature, size, and complexity of the relevant bank, building society, or insurer. It will help Firms to better understand potential weaknesses in business plans, will improve risk management practices and frameworks, will improve contingency planning, and will aid a Firm’s senior management or governing body in business decision making and the management of Firm risks.

If you would like to discuss any of the implications of RST on your business, or for more information on our Solvency II reporting solutions and prices, please email DataTracks at:

[1] FSA (2008). Stress and scenario testing. Consultation Paper 08/24 (December), Financial Services Authority; FSA (2009). Stress and Scenario Testing – feedback on CP08/24 and final rules, PS09/20, Financial Services Authority.

[2] Tail Risks are events that have a low probability of occurring and are situated at the end of a normal distribution curve.

[3] Basel Committee on Banking Supervision (2009). Consultative Document. Principles for sound stress testing practices and supervision. (January). Bank for International Settlements.

[4] Basel Committee on Banking Supervision (2009), p.19.

[5] A Firm is required to update its RST more frequently if it is appropriate to do so if there are changes in the market or macroeconomic conditions.

[6] SYSC 20.2.4.

[7] GENPRU 1.2.30 R.

[8] SYSC 20.2.5.

[9] SYSC 20.2.6.

Schedule A Demo

Schedule A Demo