Reverse Stress Testing (RST): The Return of ‘Adequacy’

RST is one of the additional challenges that financial regulators have added following the financial crisis.  I spoke today on the subject at an event organised by the Institute of Risk Management. 

The effective implementation of RST builds on the articulation of the underlying business model.  This is something that UK supervisors have put on the agenda recently to signal a more holistic approach to supervision.  I have written a number of posts on the subject which you can access here.   

There are a number of challenges to deliver a RST.  The return of ‘adequacy’ might seem an odd title for my presentation.  It seeks to convey a simple message about the main challenge of RST: the assessment and judgement about the resilience of the business model.  It’s a ‘return’ because the term ‘adequacy’ used to be more prominent.  You may remember the Capital Adequacy Directive before it became the Capital Requirement Directive.  Anyway, the graph below seeks to illustrate the challenge of adequacy, which also serves to bring on a page the various stress and scenario tests that banks and insurers are considering on a regular basis. 

The key message from the graph is that if business failure scenarios are ‘close’ to the 1-in-200 scenarios, the adequacy of the business model and the strategy could be challenged.  Management may need to consider how to mitigate the risks to the business model. 

The full set of slides is available here.

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Stress Testing: Reporting or ‘So What’?

The Bank of England (BoE) recently published the results of the first concurrent stress testing of UK banks (click here for a post about the implications of this exercise).  Stress testing is not only relevant to banks; EIOPA also initiated a similar process and carried out an exercise in 2014, which I will cover in a future post.   

Much has been written about the results for individual banks.  I would like to share some observations about an aspect of stress testing with wider implications: the consideration of ‘so what’ that may take place when the stress materialises. 

In the BoE stress testing, banks had to spell out the management actions they envisaged taking.  These actions were subject to scrutiny by the Bank of England and ‘a high threshold was set for accepting’ them. 

There is little detail about the specific management actions that were accepted.  Broadly speaking, they appear to be mainly reduction in costs and dividend.  Furthermore, the BoE clarified that they did not accept management actions that resulted in a unilateral reduction in credit supply in the stress scenario.  This approach meant that management actions had limited impacts, specifically no impact for two banks and, for the other six banks, an average improvement (i.e. an increase in common equity Tier 1 [CET1] after the stress) of 9%.  

In an earlier post (here), I suggested the consideration of ‘so what’, including the ability to carry out actions that mitigate the impact of the stress as one of the potential benefits of stress testing.  How should we reconcile this with the limited scope of management actions recognised in this exercise?

A useful starting point would be to make a clear distinction between stress testing undertaken for different purposes and audiences.  This is summarised in the table below:

	‘Internal’	‘External’ / BoE
Purpose	Identifying vulnerabilities and addressing them	Evidencing overall resilience
Focus	Lines of business/ business units	Enterprise wide

Given the BoE’s intention to continue stress testing and make them an integral part of the supervisory landscape, the question would be how to integrate these two different perspectives of stress testing. 

Ideally, a bank would start an internal review of stress vulnerabilities at the business unit level as soon as the submission to the BoE is delivered.  This would enable the bank to identify and put in place the appropriate risk mitigation.  For example, the bank may choose to adjust its credit risk mitigation by transferring loans or hedging credit before the next BoE stress testing.  Given the focus on addressing vulnerabilities, which could require board approval, it would make sense to review stress vulnerabilities of specific business units/lines of business on a staggered basis. 

Adopting this approach over time would deliver a virtuous cycle of identification of stress vulnerabilities and enhanced risk mitigation which would be reflected in the next stress testing for the BoE.

In conclusion, while the BoE may have adopted ‘a high threshold’ for accepting management actions, banks can still build in a process to identify and implement these management actions and evidence how they address vulnerabilities in key business units and product lines.

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