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Do you know under which scenarios your financial institution
faces the risk of failure? Is it likely to be a result of scenarios
that lead to physical risks to your institution? Which scenarios
would lead to the highest losses on exposures to sectors exposed to
transition risks from climate change policies?
Reverse stress testing is one of the most powerful scenario
analysis tools available to risk managers and regulators. Like
typical stress testing exercises, reverse stress testing also
encourages institutions to explore the fault lines in their
business models and vulnerabilities in their risk exposures.
However, there are key differences in the process and the scenarios
between the two approaches for stress testing.
Typical financial stress testing
In a typical stress testing exercise (link:
https://ihsmarkit.com/products/alternative-us-global-scenarios.html),
the process starts with a macro-financial scenario designed to test
the bank's resilience to a shock in one or more key drivers of the
risks undertaken. Models and scenarios designed in the preparatory
phase of the exercise are linked to exposure data to estimate
losses, capital depletion, or liquidity shortfalls.
Depending on the purpose and outcome of the exercise, the
institution or the regulator can take a range of actions from
increasing capital buffers, to enhancing risk modeling
methodologies, processes, or governance of the financial
institution.
A simplified flow of a typical stress testing
exercise
Reverse stress testing
On the other hand, reverse stress testing requires the risk team
to identify and assess circumstances that would lead a firm's
business model to become unviable or its counterparties to lose
confidence to a critical point. This may be a point at which all or
a significant portion of the firm's counterparties become unwilling
to continue transacting with it. It could also be a point at which
the firm's shareholders are unwilling to provide new capital.
As such, the reverse stress testing exercise motivates risk
managers to focus on a select few scenarios amongst many
possibilities to identify events or series of events, which lead to
failure. If the probability of such a scenario is unacceptably
high, the exercise reveals a significant risk of failure. In this
situation, realistic measures and action plans must be devised to
mitigate or avoid the risk of failure. It is worth highlighting
that this point of non-viability may be reached well before the
firm's financial resources are exhausted.
The reverse stress testing process
Regulatory guidance on reverse stress
testing
While regulators and institutions have placed renewed focus on
stress testing in the aftermath of the Great Financial Crisis,
reverse stress testing has found its place in the guidance provided
to financial institutions by various regulators from around
2015.
Since then, Bank of England's Prudential Regulation Authority
(PRA) has included a section on reverse stress testing in its
supervisory statement on
Internal Capital Adequacy Assessment Process (ICAAP) and the
Supervisory Review and Evaluation Process (SREP). The latest
version of the statement notes that "… a firm could 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... would cause the firm's
business to fail."
European Banking Authority (EBA) also notes in its 2018 final
report on
Guidelines on Institutions' Stress Testing that few competent
authorities required the institutions under their supervision to
conduct reverse stress testing, and when they did, often only as
part of recovery planning. In the same report, EBA established the
requirements from institutions to perform adequate reverse stress
tests as part of their stress testing programs. The guidance
highlighted the importance of reverse stress testing efforts to
have the same governance, effective infrastructure, and quality
standards also considering the principle of proportionality that
applies to entire stress testing across the enterprise.
Basel Committee on Banking Supervision (BCBS) also published a
report on Supervisory and Bank
Stress Testing: Range of practices in 2017. According to this
publication, reverse stress testing is conducted as a complementary
stress test by two-thirds of the institutions despite only a few
supervisors conducting or mandating such stress tests.
Financial Conduct Authority in the UK has also included reverse
stress testing in its June 2020 Finalised Guidance (FG 20/1 Our
framework: assessing adequate financial resources). In this
guidance, FCA provided the following scenarios as examples of
reaching the point of non-viability:
The market loses confidence in a firm, resulting in the loss of
a substantial portion of counterparties or clients
Complications arising because of material dependencies on group
entities (e.g. services, funding, reputation, etc.)
Existing shareholders are unwilling to provide new capital to
the firm
Scenario development for reverse stress
testing:
The nature of the reverse stress testing exercise implies its
starting point is an exploration of an institution's known
potential vulnerabilities. Therefore, risk managers should conduct
comprehensive fact-finding exercises on a regular basis to identify
internal and external factors that can exacerbate the potential
weaknesses of their specific institution, bearing in mind the
changing operating environment and marketplace over time. In
assessing these potential weaknesses, risk managers should
systematically review and carefully consider (amongst others)
trading and loan book exposures, counterparties, sector, product or
geographical concentrations, involvement in complex financial
instruments, liquidity position, operational vulnerabilities (e.g.
fraud, cyber-attacks, violence risks), and reputational risks.
An institution may want to conduct a reverse stress test focused
on weakness(es) that have been revealed because of a previous
stress testing exercise carried out as part of a regulatory
requirement or internal capital adequacy assessment process.
Institutions can also use their historical loss experience to
identify specific areas where a disastrous event could cause
failure or loss of confidence. The historical losses can also draw
upon the circumstances which led to failures of other financial
institutions such as those the during Great Financial Crisis
(2007-2009), the Savings and Loan Crisis (1986-1995), or the
collapse of Long Term Capital Management (1998).
Once the vulnerabilities have been identified, the scenarios are
constructed to stress these to the point where bank failure
would occur, with the likelihood of these scenarios
determining the measures and action plan that needs to be taken by
the management. The academic literature also includes various
quantitative and algorithmic approaches that institutions can use
to come up with scenarios suitable for reverse stress testing
particular financial risks.
Therefore, the necessary ingredients for a meaningful and useful
reverse stress testing exercise include inter alia:
Knowledge of the institution, its business model, exposures,
and potential weaknesses
Information and data across a range of industries and
countries, as well as experts including social and political
scientists, economists, mathematicians, data scientists, cyber risk
specialists, and a wide range of industry risk professionals.
Data and comprehensive models that link the global economy,
price changes, industry impacts, and risk factors.
Expertise (and imagination) to devise the most challenging
"what-if" scenarios
One of the ways we model risk is to identify realistic and high
impact scenarios to assist in planning against credible futures,
without necessarily re-running the past. For example in recent
realistic disaster scenarios, our analysts have explored two
difficult "what if" questions:
What if a regional war breaks out in the Middle East?
considered what it would look like if, instead of our current view,
nuclear negotiations were to stall amid escalating retaliatory
attacks, culminating in Iran, the US, and Israel entering into a
regional war.
Similarly, in another realistic disaster scenario, our analysts
explored the scenario in which Latin America enters the second year
of economic recession, is hit by a third wave of COVID-19 with a
surge in the number of COVID-19 cases overwhelming hospital
facilities, all of which triggers
a surge in violent unrest across the region.
Economists can use these scenarios to quantify their impacts in
macroeconomic terms to provide an array of macroeconomic and
financial risk drivers. Furthermore, risk models can translate
those drivers to stressed risk parameters, stressed loss, capital
or liquidity projections. Risk experts can evaluate the outcomes
against the vulnerabilities of the institution to see if thresholds
are breached. The narrative and severity of the scenarios could be
adjusted in case additional stress is required to push the bank
vulnerabilities to the "breaking" point. Ultimately this would help
to identify scenario(s) under which bank business model becomes
unviable.
Best practice stress testing exercises incorporate historical
experience with forward-looking insights and projections. To this
end, quantitative financial modeling and expert judgment are
equally necessary to identify the potentially ruinous events and
their impact on the solvency, liquidity, and reputation of the
institution. Failure of a financial institution can be caused by a
multitude of causes and combinations. Hence institutions need to
consider a broad range of scenarios including realistic disasters
for their reverse stress testing. This is also one of the reasons
why financial regulators around the world are incorporating
environmental, social, and governance (ESG) factors into their
stress testing frameworks with particular focus on the impact of
policies to contain climate change, carbon emissions, and global
warming.
Posted 10 August 2021 by Metin Epozdemir, Head of Global Regulatory Stress Testing and Scenario Analysis, S&P Global Market Intelligence