Reverse stress testing is by no means a new concept; however, it is seen as good practice for firms, which are within scope. Reverse stress testing is a regulatory topic that is gaining increasing prominence within the Risk-Management Framework tool-kit, and is now more broadly applicable for a larger population of firms, as set out in FCA’s guidance statement FG20/1.
FG 20/1 states “A firm should consider scenarios of adverse circumstances affecting a firm’s business model and strategy, where the ability to generate returns is beyond a firm’s risk appetite to stay in business, or where the firm is unable to meet its legal requirements to remain solvent, determined as the point of non-viability. A reverse stress test must result in a firm reaching a point of non-viability and should provide useful information about vulnerabilities in a firm’s business model and strategy. This should help when designing measures to prevent and mitigate the risk of business failure.”
FG 20/1 contains detailed guidance on the objectives of a reverse stress test, in creating a feedback loop for risk mitigation and strategic initiatives. The key component parts of the reverse stress test that ensure an effective feedback loop include:
- Point of non-viability which is specific e.g. the market loses confidence in a firm, resulting in the loss of a substantial portion of counterparties or client and provides a framework to which scenarios are anchored.
- Scenario and scenario events, which threaten the viability and sustainability of the firm’s business model, and are firmly anchored in the point of non-viability. Scenario events that have clearly defined qualitative and quantitative impacts.
- Management actions, which mitigate the impacts of scenario events, and should be credible, available, effective at mitigating risk and impactful.
- Modelling the reverse stress, based on the latest approved budget, applying the impacts of scenario events, with the additional impacts of management actions, and finally identifying the point of non-viability through financial modelling.
- Incorporate feedback from reverse stress testing into the risk management and strategic framework. Each of the four steps above should offer feedback that should be incorporated into the risk management framework and strategic decision making inputs, including:
- Vulnerabilities in the business model e.g. via scenario events design, and addressing these vulnerabilities via strategic changes;
- Weaknesses in risk appetite framework; for example if there is no available risk appetite threshold to monitor a key risk identified, and updating risk appetite framework to capture all relevant risks to the business model, such that monitoring of risks is complete and effective.
- Weaknesses in management action plans, for example where a management action such as sale of business may not be available under stress. The firm’s list of management actions can then be updated so that they are credible and are integrated with other risk management tools such as recovery planning.
- Weaknesses in risk identification, for example RST scenario design may reveal risks that are not captured within the firm’s risk register. Risk registers and operational risk scenario design may then need to be updated ensure all risks are identified, documented, monitored and managed appropriately.
Reverse stress testing is ultimately a risk and strategic management framework tool. A tool that can unveil vulnerabilities to the business model, weaknesses in the identification, capturing, monitoring and management of risk and provide insight into future risks that can be proactively addressed. When done well, reverse stress testing is a powerful tool to assist management in setting risk appetite, as well as strategic decision making.