Join Mailing List

For latest news and information about Treasury and Financial Markets, enter your details below:

Reverse stress testing

Print Preview Send to a Friend Share

Published: 20th August 2010 by William Webster

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.

Why reverse stress test?

Because it’s a disciplined process of finding weaknesses in you 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.

How does this vary with stress testing?

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.

What does the regulator say?

Full discussion and the legal instrument are found in FSA Policy Statement 09/20. Here are two extracts:

20.2.1 R ".....a firm must reverse stress test its business plan; that is, it must carry out stress tests and scenario analyses that test its business plan to failure..."

This involves identifying a range of circumstances that cause the business plan to be unviable and assess the likelihood of this happening.

Where this reveals an unacceptable risk of failure considered against the firm's risk appetite the firm needs to prevent or mitigate the risk.

20.2.3 R "The design and results of a firm's reverse stress test must be documented and reviewed and approved at least annually by the firm's senior management or governing body...."   

Finally

Two banks that appear to be similar may have different reverse stresses.

Is there a plausible reverse stress test you haven't considered?

Displaying 1 to 6 of 6 results in total.

Related Documents

Registration RequiredRegulation > Consultation Paper 08/24 Stress and scenario testing December 2008 100% relevant

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.


Registration RequiredRegulation > Policy statement 09/20 Stress testing and scenario testing December 2009 99% relevant

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.


Registration RequiredReverse stress testing is not stress testing 76% relevant

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.


Free to ViewWhat's your appetite for stress testing? 44% relevant

16th June 2010

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.


Payment RequiredMarket Guides > Liquidity risk explained 40% relevant

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.


Registration RequiredRegulation > Consultation Paper 08/22 Strengthening liquidity standards December 2008 37% relevant

31st January 2009

This CP sets out the FSA's plans to reform the liquidity regime. It requires firms to undertake a much more rigorous analysis of their liquidity position. This includes the effect of stressed conditions on their business. The firm will submit what it considers to be an appropriate liquidity buffer to the regulator. The FSA will then decide whether it is sufficient. In determining the buffer the FSA will also assess the firm's systems and management. If these are considered weak the buffer will be increased accordingly. The liquidity buffer can only be held in liquid assets. The FSA's view is that this primarily means Gilts, sovereign debt or central bank deposits. The FSA makes it clear, "The responsibility of adopting a sound approach to liquidity risk management is on firms and their senior management".