101: Stress Testing and Scenario analysis

Stress Testing and Scenario analysis

Background

Stress Testing

Stress testing is a risk management tool for firms to evaluate the potential impact of an unplanned event or movement on the firm’s asset quality, profitability, capital and other financial variables. It permits a forward-looking analysis. It is inextricably linked to the establishment of risk appetite and is critical to the ongoing monitoring of risk appetite. Stress testing incorporates risk into the planning process by providing the “what if” scenarios for the strategic and capital planning process. Finally, stress testing should lead to a call for action. Actions may take the form of developing contingency plans, reducing concentrations, determining the appropriate dividend, or raising capital through equity or debt.

Types of stress testing.

There are three types of stress testing.

Sensitivity Analysis involves changing and stressing variables, parameters or inputs without an explicit underlying reason or narrative.

Scenario Analysis involves historical or hypothetical scenarios to assess the impact of various events. Scenarios usually involve a coherent , logical narrative that describes how the events occur and in which combination and order. Scenario analysis is the process of evaluating the impact of specified scenarios on the company’s financial position. Scenario analysis typically refers to a study where a wide range of parameters are varied simultaneously. The scenarios could be chosen as events intended to have a defined probability of occurrence, for example, a ‘one in a hundred years’ event.  A scenario is an adverse development of a number of interconnected risk factors or parameters – The application of scenario analysis shows the complex dependencies between several risk factors and the related KPIs.

Reverse stress testing assumes a known adverse outcome and then deduces the types of events that could lead to such an outcome. This types of stress testing helps to consider scenarios beyond normal business considerations and challenge common assumptions.

Principles. 

  1. Plausible. They must be realistic, i.e. have a reasonable probability of actually occurring.

  2. Consistency. They should be consistent with existing quantitative frameworks.

  3. Adaptive: Stress scenarios should be specifically designed for the firm

  4. Reportable. They should provide information that can be translated into concrete action.

Aims

  1. Stress testing and scenario analysis should therefore: − Help identify the most relevant risk drivers: stresses and scenarios enable the responsiveness of one or more risk drivers to changes in the risk model and in the external environment to be investigated.

  2. Understanding the cause-effect relationship between stresses and changes in the risk profile of a company allows senior management to take prompt business decisions.

  3. Evaluate the viability of the business plan: forecasting the impact of stresses and scenarios on the business plan may prove the viability of the business plan itself.

  4. Test the robustness of risk models: checking the sensitivity of models to different and divergent stresses may help to evaluate the effectiveness and robustness of tools or risk models.

  5. Challenge risk triggers and limits: by running stress testing and scenario analyses, a company can evaluate the adequacy and practicability of limits and triggers.

  6. Assess forward-looking components of the risk profile: multi-year scenario analysis includes predictions of a company’s future situation; future stresses and scenarios may help to forecast the future situation more accurately.

Implementation

Some of the key activities will be:

  1. Deciding on the risk measure.

  2. Development of a risk language and common definitions.

  3. Detailed investigation of the company’s operations.

  4. Data capture and analysis.

  5. Setting of assumptions.

  6. Scenario and stress modelling.

  7. Investigation of how risks can be mitigated,

  8. Recording and reporting of results.

  9. Discussions with internal and external parties, such as the regulators.

Benefits

1. Shapes the risk profile of your organization through better understanding of risk by providing a forward looking view  and focusing management on the future strategy.

2. Identifies risk concentrations across various business lines and allows management to form contingency plans,  provides for the integration of business strategy, risk management, and capital planning.

3. Promotes discussion about risk that leads to enhanced internal and external risk communication.

4. Stress testing can and should assist in identifying strategic opportunities.

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John Thackeray