At a glance
- A focus on their stress testing culture can help financial services firms meet supervisors’ expectations that stress testing is firmly embedded within wider risk management and strategic decision-making frameworks.
- To achieve the embeddedness supervisors expect, firms need to reframe the purpose of stress testing, recognising the wider role it can play within the business and the wider social context. They need to communicate the benefits and insights of stress testing more widely and align incentives to ensure stress testing is embedded within operations, decision-making and the risk management framework.
- To strengthen the review and challenge of the stress testing framework, firms should harness “diversity of thought” through encouraging a range of stakeholders to give their views on assumptions, results and performance as well as ensuring strong governance, controls and senior manager oversight.
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Whereas the initial supervisory focus on stress tests was financial resilience, increasingly supervisors are shifting their focus to the qualitative aspects of stress testing and, in particular, how well embedded stress testing processes are within firms ’ operations, strategic decision-making and risk management frameworks.
“Rather than measuring the actual size of capital holes against a supervisory yardstick, stress tests now help us to spot vulnerabilities in banks. Also, the dialogue between supervisors and banks has become more important as the stress test is seen as a tool to strengthen banks’ own risk management”. Andrea Enria
The Bank of England’s (BoE) qualitative review of banks’ stress testing found that whilst banks have made substantial improvements to their stress testing frameworks, these have largely been confined to stress tests commissioned by the supervisors, and could be extended to enhance internal stress testing capabilities. The BoE also found that whilst banks use stress testing to calibrate risk appetite and limits, they could do more to embed stress testing in their planning and business as usual risk management capabilities and use it to review strategic and business decisions, identify business vulnerabilities, and inform key decisions on the future direction and management of the bank. Similar issues were raised in the European Central Bank’s (ECB’s) recent guidance on the ICAAP and are considerations underlying the ongoing review of the future of stress testing.
For insurers, supervisors have similarly emphasised the relationship between stress testing and the wider risk management framework. For example, following its 2018 stress test, EIOPA recommended that National Competent Authorities (NCAs) should carefully review and challenge the capital and risk management strategies of the groups affected by its stress test ; whilst the PRA has highlighted that, “central to the concept of the ORSA is that it may be used to demonstrate strong linkages between business strategy, risk, capital, and stress testing”.
Supervisors expect sustained improvements in firms’ stress testing capabilities over time. For example, should banks fall short of its expectations, the BoE has said it may use the findings from its qualitative reviews to inform the setting of the capital buffer and the intensity of supervision of individual banks. Moreover, the BoE states that its findings could be used to inform supervisory feedback on how stress testing should be reflected in the responsibilities and remuneration of individuals performing Senior Management Functions under the Senior Managers and Certification Regime (SM&CR)
Culture as a solution
Whilst much has been said about the key role that risk culture plays in embedding a robust approach to risk management, less attention has been paid to the culture that drives firms’ stress testing practices. In fact, a focus on stress testing culture (including internal stress tests such as reverse stress tests and scenario analysis) can help firms accelerate their response to supervisory expectations and secure a shift in the mindset that surrounds stress testing such that the business comes to recognise its potential to help to identify vulnerabilities, improve decision-making and manage risk more appropriately.
It is often said that culture is what people do when no one is looking. Whilst supervisory authorities may have, in some cases, cancelled some 2020 stress test submissions in light of COVID-19, supervisors will, nevertheless, expect firms to maintain focus on enhancing their stress testing capabilities. Moreover, a strong stress testing culture will, in our view, aid firms’ recovery from COVID-19 by encouraging them to leverage the insights gained through their stress testing for the benefit of the wider business. For example, the insights generated by credit risk modelling could be used to help operations and customer-facing teams understand which customers cohorts/segments are likely to require ongoing financial support, and when, so that they can plan and deploy their resources appropriately. In turn, risk management practices such as collections and recovery options in retail banking and the effective inclusion of these as management actions in a stress test should be influenced by and realistically adjusted for leniencies and exceptions made in these special circumstances.
Based on our experience of working with firms to enhance their corporate and risk management cultures, we have identified some of the common drivers of culture (and sub-cultures) within a firm and considered how these can be applied to help firms further embed stress tests into their planning and risk management frameworks. We pose key questions the Board and CROs can ask themselves to identify areas of their stress testing culture that require enhancement.
A more detailed list of questions can be found in the attached document along with a number of suggestions as to how firms can begin to close any gaps.
By ”purpose” supervisors mean what a firm is trying to achieve in practice, not just in theory, and how this purpose is understood by the rest of the business. To achieve the embeddedness and integration supervisors expect, firms should start with what they consider the purpose of stress testing to be, and the extent to which it is used to inform wider decision-making by the firm.
The “tone from the top”
In addition to bearing ultimate responsibility for the overall stress testing framework, the Board and Senior Management play a key role in setting the ”tone from the top” in relation to stress testing, communicating the business benefits of better integration and embeddedness, and challenging the assumption that it is a compliance ”overhead”, rather than an opportunity to enhance the business.
Individual accountability and collective responsibility
Any perceived weaknesses in the firm’s approach to stress testing may heighten scrutiny of the “reasonable steps” the senior manager holding the prescribed responsibility for the firm’s internal stress tests took to discharge their duty. Moreover, as senior management committees are expected to operate in a spirit of collective responsibility, weaknesses may give rise to questions about how the Board assured itself that the stress test results were reliable, including the information upon which it relied.
Challenge and diversity of thought
Supervisors expect firms’ stress testing frameworks to be subject to credible challenge at multiple points and through multiple levels within the firm. To strengthen the review and challenge of stress testing, firms should promote diversity of thought and a culture of openness where a range of key stakeholders are encouraged to provide feedback on the assumptions, results and performance of the stress testing framework. Encouraging business areas to challenge assumptions, and the plausibility of predicted outcomes, ensures that the stress test is not a “purely statistical or hypothetical exercise”.
Governance and controls
Good governance is critical to achieving a sound stress testing culture. Supervisors will be concerned if the firm does not attach sufficient priority to robust stress testing governance and controls and are likely to view weak stress testing practices as symptomatic of a poor culture overall. The governance structure should be clear, comprehensive and documented. In addition to specifying the roles and responsibilities of senior managers, there should be clarity regarding the roles and responsibilities for all aspects of the stress testing framework, including the role of the second and third line. This is especially relevant as stress testing covers new ground such as climate risk.
Incentives and remuneration
Incentives are a key driver of (sub)culture within a firm. Firms can look to embed a robust stress testing culture by aligning incentives, including remuneration, with the embedding of stress testing in operations, business decision-making and the risk management framework. For example, rewarding review and challenge of the stress testing framework and results or better use of stress testing results in strategy setting.
Enhancing stress testing culture
Figure A sets out how the drivers we have identified can be applied across the typical phases of a stress testing framework.
Stress testing increasingly consumes a significant amount of time, effort and expense within firms. Yet some fail to extract the full benefits of their investment by acting on the insights gleaned and aligning these to their longer‑term objectives. Reframing the purpose of their stress tests, and communicating the insights more widely can help firms realise the benefits and competitive advantages of risk-based, strategic decision-making.
Firms could accelerate and gain traction for enhancing their stress testing culture by making improvements as part of a wider focus on achieving a risk intelligent culture and addressing what Andrew Enria, Chair of the ECB has described as: “[…] severe weaknesses in the internal controls of banks, lack of effectiveness in their management bodies and deficiencies in their risk management”. Focusing on risk culture will ensure that risk management, including stress testing and scenario analysis, is rigorously applied to all activities, from strategic planning to day-to-day operations and that employees understand, and are able to articulate in a compelling way, the value that it brings to the organisation.