UK FSA Mandates Reverse Stress Testing in New Stress Testing Regime

The UK Financial Services Authority has strengthened its stress testing regime by requiring firms to improve their stress testing capability, and, for the first time, introducing a reverse stress testing requirement for firms. The reverse stress-testing mandate would require a firm to identify explicitly and assess the scenarios most likely to render its business model unviable. A firm’s business model would be unviable at the point when crystallizing risks cause the market to lose confidence in the firm.

A consequence of this would be that counterparties would be unwilling to transact with or provide capital to the firm and, where relevant, that existing counterparties may seek to terminate their contracts. Such a point could be reached well before a firm’s regulatory capital is exhausted. Firms subject to the new reverse stress testing requirement will have 12 months to incorporate reverse stress testing into their current suite of stress tests and risk management tools.

Paul Sharma, FSA Director of Prudential Policy emphasized that stress and scenario testing should be an important element in firms’ planning and risk management processes. The changes send a clear signal to firms’ senior management that they need to engage in building a robust stress testing infrastructure as an important part of effective risk management, and use that to assess capital needs in a stress.

With regard to reverse stress testing, the Director said it is essential that firms identify what could cause their business to fail and use this information to ensure that the relevant risks are sufficiently well-understood and appropriately managed to secure consumer protection and market confidence.

The FSA views reverse stress testing as an important complement to the suite of stress tests that firms are required to carry out. The new reverse stress testing mandate is designed to encourage firms to explore more fully the vulnerabilities of their current business plan, including milder adverse scenarios, and make decisions that better integrate business and capital planning, as well as to improve their contingency planning.

The primary use of reverse stress-testing is as a risk management tool to improve business planning and risk management rather than to inform decisions on appropriate levels of capital or liquidity specifically. Regulators are likely to review a firm’s reverse stress-tests as part of risk assessment and regard reverse stress-testing as a complement to these processes.

Another important benefit of reverse stress-testing is the thinking behind the scenarios. The FSA expects mandated reverse stress testing to encourage improved understanding of risks throughout an organization, especially at senior levels. This should ensure that adequate attention is given to scenarios in which a firm’s business model would become
unviable and that appropriate strategies, risk mitigation and contingency plans are in place.

The reverse stress testing mandate incorporates the concept of proportionately. Thus, smaller, less complex firms would be expected to conduct less complicated reverse stress testing, possibly more qualitative than quantitative. Larger, more complex firms would conduct more extensive stress testing, both qualitative and quantitative in nature.

The design and results of a firm’s reverse stress test must be documented, reviewed and approved at least annually by the firm’s senior management or governing body. A firm is required to update its reverse stress test more frequently in light of substantial changes in the market or in macroeconomic conditions.

.