Reverse Stress Testing

Reverse stress testing is one of the hottest topics around the world in banking sector. Reverse stress testing is conducted as a complementary stress test along with other general stress tests. The key difference is that with a reverse stress test, the financial institution identifies the kind of scenarios that threaten the sheer survival of the firm. These are the scenarios under which the business model becomes unviable and the firm fails.

The key objective of the reverse stress testing is to overcome disaster myopia and the possibility that a false sense of security might arise from regular stress testing in which institutions identify manageable impacts.

Reverse stress testing is done by starting with a business failure outcome, and then analysing different scenarios under which such failure may occur.

A firm’s business model is described as being unviable at the point when crystallising risks cause the market to lose confidence in the firm. A consequence of this would be that counterparties and other stakeholders 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.

According to FSA, the intention behind this new requirement was to encourage firms to: first, explore more fully the vulnerabilities of their current business plan (including ‘tail risks’ as well as milder adverse scenarios); second, make decisions that better integrate business and capital planning; and third, improve their contingency planning.

The use of reverse stress testing is primarily seen as a risk management tool. The key benefits include:

• Helping firms to understand key risks and scenarios that may put business strategies and continuance as a ‘going concern’ at risk; and
• Providing management and regulators with qualitative information on the potential vulnerabilities faced by the business so that they can identify appropriate actions that should be taken to manage such risks.

Reverse stress testing is not expected to result in additional capital planning and buffers. It is used in reviewing the firm's business model, strategy and capital requirements. It also provides useful insights that the bank can use to improve their contingency plans.

The EBA stress testing guidelines (GL32) requires firms to regularly carry out stress testing, using a mix of qualitative and quantitative approaches depending on the size and complexity of the firm.

An alternative proposed terminology for this is ‘business model stress test’.