Dealing With Uncertainty - Part Two

Published: 16th June 2020

In Part One I summarised that:

There are three types of stress test and you need to be aware of which you are using.
In our business we have assumptions and guesses about people’s behaviour and the future.
This means our tests are approximations of risk.
We aren’t dealing with construction and we aren’t engineers therefore red, amber and green paints a simple but potentially misleading picture.

Models and approximations

Following on, one of the main threats we now face is Covid 19. It’s a fact that no stress test contained it, why would it? But now it’s happened it highlights the weaknesses of our models. What’s more the uncertainty in health now widens the range of economic outcomes:

“In all of the countries whose data we analysed, the best fit to that data favours the second explanation…….the infection may have spread far enough to mean that the trajectory of falling new cases could be maintained with some easing of restrictions. Policy on how far to ease restrictions will inevitably have to be made in a fog of considerable uncertainty.”

“Assessing the spread of the novel coronavirus in the absence of mass testing”. Oscar Dimdore-Miles, Department of Physics, Oxford University and David Miles Professor of Financial Economics, Imperial College Business School

With such uncertainty we should ask how we can make better use of our models, which are after all approximations, to find out more about uncertain things, things like:

What if? – Make small changes to the assumptions going into your model and find out what happens to capital, liquidity and survivability.
Behaviour – Are you offering customers free options where they can drawdown or repay on their terms? Can you quantify what this could cost? Are there surprises? Can you redesign products to mitigate the effects?
Concentration – Is there a particular counterparty, market, product, channel etc that if it ceases to operate leaves you over exposed? Could it take you down?
Risk appetite – How much risk can we sustain? How do we link it to profit and capital resources? Is our exposure in an area where we have an edge? Are we being sufficiently well paid for the risk we take?
Buffers – How are these insurance policies, that build in reserves, sufficient to see us through? How do we link the period we expect them to last to our risk appetite?

In a world where our risk has now increased the natural inclination is to add to buffers as a way of protection, but this can become ruinously expensive.

To offset this, the more levers you can pull and the more effective they are, the more you manage such costs. There are big gains therefore to be had from understanding this and also the role flexibility, (aka management action), plays in determining self-insurance.

They key is to determine whether you can realistically change the speed of cash flows or mitigate adverse supply or demand conditions on a timely basis by your actions.

Something’s missing

That’s finding out about unknown threats that can take the business down (the “unknown, unknowns”). This is very difficult to do; it requires an exceptional degree of insight that’s always obvious after the event - hindsight is a wonderful thing.

To explore these weaknesses, we are encouraged to use Reverse Stress Testing but what this is and how works is open to conjecture.

The Bank of England comments “Reverse stress tests are stress tests that require a firm to assess scenarios and circumstances that would make its business model unworkable, identifying potential business vulnerabilities.”

Here’s what I wrote in 2010:

“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.

Because it’s a disciplined process of finding weaknesses in your business and deciding on the action that needs to be taken.

"Tail risks" (low probability high loss events) are dangerous because they occur more frequently than models predict.

Identifying these extreme events gives you a better chance of survival. You can decide whether you are within your risk tolerance or whether some form of action needs to be taken.

It is an additional risk management tool.

Reverse stress testing is about plausible scenarios outside your normal stress testing requirement.

Let's look at an analogy.

In the world of aviation aircraft are designed to withstand serious and repeated stresses. Engines are run to destruction to ensure that in the normal course of flying the power plant always performs. But what happens if two out of four engines fail?

Knowing the answer may help you avoid catastrophe.

Let's look at banking

What could cause your largest wholesale counterparty to fail? And what are the consequences for you? Does it tell you anything about the level of risk you currently run?

What's the role of the Board?

To use its experience and understanding about the way the business works to decide on the appropriate reverse stresses, what their impact could be and whether action is required.”

One of the greatest difficulties comes from a simple question. “Just how do you do it?” In the last decade I’ve seen three approaches:

Breakpoint - increase a stress to a point where the firm fails. For example, what percentage of retail funding needs to go within 90 days before we fail?
Failure – decide on scenarios that are highly unusual, but would if followed through, lead to failure. For example, negative interest rates over a long time period.
Backwardation - start with the failure from a stress test and determine whether there is a realistic (albeit most unlikely chance) it could occur. For example, we run out of capital as a result of this stress, what economic scenario could cause this?

The important thing is not how you do it but what you make of it.

With conventional stress testing you find out whether your business will survive predetermined events, whilst reverse stress will chip away at the foundations and ask how structurally sound your business really is.

Done well it’s a useful adjunct to what we do and that’s why I’m surprised more use is not made of it.

Surely it would be sensible for any board to take some straight forward information about what causes the firm to fail and then consider whether there are certain plausible scenarios that could make this happen and whether there is something they can do, which over time, will improve the potential outcome.

Summary

Our industry always faced huge uncertainty and our leverage magnifies the consequences of getting it wrong.
Stress testing uses unreliable models and assumptions and for this reason red, amber and green gives us false comfort.
We can get more from our models by using estimates of how our business may work and at the same time try to build in management action that improves flexibility. Such self-insurance reduces the cost of idle buffers.
This is more important now Covid 19 has widened the range of possible outcomes.
Reverse stress is controversial but assessing your vulnerability to unlikely events can help you find weaknesses that would otherwise go unnoticed. This isn’t about predicting pandemics, it’s about seeing things you already face. Do they have the potential to take you down?
This is the remit of the Executive and Board.

First published on Linkedin, June 2020