What's your appetite for stress testing?

Published: 16th June 2010 by William Webster

What's your appetite for stress testing?

A lot's been written about the board's appetite or tolerance for risk. But very little has been said about what this means. Perhaps this will help.

It's not long ago when the following statement was regularly found in the policy statements of financial institutions "we are conservative and do not take unnecessary risk with shareholders' (or members') funds".

In light of events this statement will no longer suffice. Increasingly quantitative measures need to back up the board's approach to risk appetite.

In the past when we wanted to quantify risk we assumed markets (usually) behaved "normally". This meant that we expressed risk tolerance using models that did not tell us what could happen on a really black day. But it is those really black days that threaten both the firm and systemic stability. That's why stress testing has become the regulator's favourite tool.

Stress testing shows you what happens once every 25-50 years. That's good but there is one major drawback.

Managing your business on the basis of stress test results significantly increases the cost of doing business. Consider liquidity. Holding higher liquidity buffers reduces your P&L and management's attention is quickly drawn to this inevitable fact. The temptation is to stress test for grey days not black ones.

In order to quantify liquidity risk one popular measure is "days of survival". This shows you how many days your firm can survive either firm based or market wide stress events. (Typically two weeks and three months being cited as an appropriate period for the respective stress scenarios).

For sake of simplicity suppose your management reports tell you can survive two weeks and three months under the stressed conditions. How meaningful is this measure?

It depends. It could be way off the mark.

If the cost of liquidity tempts you to reign in the severity of stress testing then compliance with the 14 day or 90 day limit is there on paper but it's meaningless. Faced with a severe event you won't survive.

That's why boards have to ask themselves this question "what is our appetite for risk in our stress testing?"

Put another way, if the regulator wants to see the board's appetite for risk looking at the stress testing assumptions is a good place to start, how severe are yours?

Displaying 1 to 6 of 6 results in total.

Related Documents

Regulation > Consultation Paper 08/24 Stress and scenario testing December 2008

12th April 2009

The FSA wants to see more stress and scenario testing in firms. Senior management should be involved. Previous assumptions have been too relaxed. Stress testing should be in detail with the mitigating actions rehearsed. Reverse stress testing is introduced as a method of identifying critical events. The FSA is not going to tell you how to do this, it's up to you. However firms can expect greater challenge on the assumptions made.

Regulation > Policy statement 09/20 Stress testing and scenario testing December 2009

18th December 2009

What's stress testing about? The regulator is imposing a stress testing regime on firms because the risk management techniques employed before the crisis did not accurately reflect what could happen. In particular risk models allowed firms (and regulators) to ignore tail-risks. As a result many firms have found themselves badly exposed in the crisis. In order to mitigate against this happening again the FSA is making stress testing and reverse stress testing mandatory. Let's answer a few questions.

What's your risk appetite?

12th June 2010

The regulator is asking boards to define their risk appetite and risk tolerance. Whilst this insistence may be reasonable it certainly doesn't make it any easier to do. Just how do you measure the level of risk you have and then how do you relate that to your firm?

Reverse stress testing is not stress testing

9th March 2011

The FSA has issued guidance consultation on reverse stress testing (Reverse stress-testing surgeries - FAQ). Some firms will fear that because reverse stress testing is relatively new the regulatory process will involve trial and error. So how can you undertake reverse stress testing and have a good chance of doing it well first time round? Using the maxim of KISS here are 24 FAQ.

Reverse stress testing

20th August 2010

What is reverse stress testing? It is the process of uncovering events that, should they occur, have the potential to make your business unviable. Such events can cover credit, market and liquidity risk. It's important to remember that business failure occurs before you run out of capital. It's when counterparties are unwilling to deal with you.

Market Guides > Liquidity risk explained

1st November 2009

A contractual cash flow report for a bank will show you that liabilities have shorter maturities than assets. That's because running liquidity risk generally makes money. But it has risks. Lack of confidence can lead to a real shortage of cash. That's why banks hold liquidity buffers. But measuring liquidity risk goes beyond what is contracted. It needs to assess the behaviour of markets and individuals. It's why stress testing is in vogue. Stress testing can't predict the future but it can give you an estimate for your liquidity buffer. It's likely to be a lot bigger than previously and it's going to cost your firm more, that's unless you can pass the cost on through transfer pricing.