P
oli
cy Statem
en
t
December 2009
09/20
Financial Services Authority
Stress and Scenario
Testing
1
Overview 3
2
Consultation feedback and analysis of responses
7
3
Reverse stress-testing
41
4
Other points
44
Annex 1:
List of non-confidential respondents to CP08/24
Annex 2:
Cost-benefit analysis
Annex 3:
Good practice in stress and scenario testing
Annex 4:
Additional guidance to insurers on the Pillar 2 capital
planning stress test
Annex 5:
List of regulatory documents relating to stress testing
Annex 6:
Our approach to stress testing
Annex 7:
List of acronyms
Appendix 1: Handbook text
Contents
This Policy Statement reports on the main points arising from responses to
Consultation Paper 08/24 Stress and scenario testing – Feedback on CP08/24 and final rules and publishes final rules.
Please address any enquiries to: Piers Haben
Pillar 2 & Stress Testing Policy Financial Services Authority 25 The North Colonnade Canary Wharf
London E14 5HS
Telephone: 020 7066 8198 Fax: 020 7066 8199
E-mail: [email protected]
Copies of this Policy Statement are available to download from our website – www.fsa.gov.uk. Alternatively, paper copies can be obtained by calling the FSA order line: 0845 608 2372.
Overview
1
1 Details on the FSA’s integrated approach to stress testing can be found in Annex 6.
2 For banks this includes all relevant capital ratios in the in the supervisory framework including individual capital guidance (ICG) and other relevant ratios:
http://www.fsa.gov.uk/pages/Library/Communication/Statements/2008/capapp.shtml http://www.fsa.gov.uk/pages/Library/Communication/Statements/2009/bank_capital_.shtml
1.1 The FSA’s integrated approach to stress testing1consists of three main elements:
• Firms’ own stress testing. We expect firms to develop, implement and action a
robust and effective stress testing programme which assesses their ability to meet capital and liquidity requirements in stressed conditions, as a key component of effective risk management.
• FSA stress testing of specific firms. The FSA runs its own stress tests on a
periodic basis for a number of firms. We do this regularly for specific high impact firms and for other firms as the need arises, to assess their ability to meet
minimum specified capital levels2throughout a stress period.
• Simultaneous system-wide stress testing undertaken by firms using a
common scenario for financial stability purposes.
1.2 The diagram below illustrates the FSA’s integrated stress testing framework including the three elements described above.
Monitoring and aggregation Setting scenarios Setting stress testing policy • Capital • Liquidity • Reverse stress-testing
• FSA stress testing of specific firms • Assessment against minimum specified capital and liquidity requirements • Simultaneous stress testing • Financial stability purposes Firms’ own stress testing Supervisory stress testing System-wide stress testing
Micro-prudential analysis Macro-prudential analysis
Interlinked analysis
FSA Objectives
3 http://www.fsa.gov.uk/pubs/cp/cp08_24.pdf
4 Internal capital adequacy assessment process rules are set out in our General Prudential Sourcebook (GENPRU) under which a firm is required to self-assess adequate financial resources to cover its particular individual risks.
1.3 These three elements are interlinked and mutually reinforcing. This Policy
Statement (PS) focuses primarily on improvements we expect to see in firms’ own stress testing – the first element identified above. In December 2008, we published Consultation Paper 08/24 (CP08/24): Stress and scenario testing3which sets out specific measures to strengthen firms’ approaches to stress testing. In addition to outlining general areas for improvement in stress testing, we formally consulted on introducing a reverse stress-testing requirement. We also consulted on clarifications of our rules and guidance in several policy areas including Pillar 2 capital stress and scenario testing (our ICAAP4rules) and where, for BIPRU firms,
internal models are used to assess Pillar 1 capital requirements. The importance of stress testing was also outlined in DP09/2, published in March 2009 simultaneously with The Turner Review, emphasising that we regard stress testing as a critical part of our regulatory architecture.
1.4 This PS sets out a summary of the responses received against each question raised in CP08/24, describes our final policy and includes the Handbook text that will give effect to that policy. We have provided additional comments where appropriate to explain our requirements. In particular we comment on the following aspects in some detail:
• Stress testing infrastructure: We remind firms about the importance that they
establish, implement and action an effective stress testing programme. We have included an annex (Annex 3) outlining good practice in this Policy Statement. • Pillar 2 stress testing: We describe our expectations for the appropriate severity
of Pillar 2 stress scenarios. We outline the role of supervisory recommended scenarios in helping firms to calibrate their own scenarios and clarify our approach to assessing the credibility of management actions in a stress scenario. • Reverse stress-testing: We introduce reverse stress-testing requirements for firms
to identify and assess scenarios most likely to cause their current business models to become unviable. We address concerns about proportionality in relation to these requirements by describing the range of approaches that firms might take. In addition, our final policy adjusts the scope of application of the requirements for investment firms, compared with the consultation proposal.
• Specific concerns from insurers: We have addressed in Annex 4 a range of issues
relating to insurers’ stress testing, to assist their understanding of our requirements, and in particular, the capital planning stress test.
1.5 Accompanying this Policy Statement is a short Consultation Paper that clarifies our approach to capital planning buffers, which are set for BIPRU firms as part of Pillar 2 capital planning, in order to help firms understand better how this buffer may be drawn down during adverse external circumstances.
Who should read this paper?
1.6 This paper should be of interest to banks, building societies, insurers, CRD
investment firms and smaller investment firms. Members of board risk committees (in particular those who are non-executive directors), senior management and chief risk officers, as individuals responsible for implementing and overseeing an effective stress testing programme within a firm, should read this paper to understand our expectations of firms in relation to stress testing. A wide range of other staff in these firms should also read this paper.
Responses and our final policy approach
1.7 The consultation period for CP08/24 closed on 31 March 2009. We received 28 responses from a range of firms, trade associations and individuals. We are grateful to all the respondents for taking time to send us their views. A list of all non-confidential respondents can be found in Annex 1.
1.8 Section 3 of this document sets out a timetable for implementation of the new reverse stress-testing requirement. Firms identified as being subject to the reverse stress-testing requirement will have 12 months from publication of this Policy Statement (14 December 2010) before the requirements become effective.
Structure of the Policy Statement
1.9 The rest of the PS is set out as follows:
• Section 2 summarises feedback received and our responses;
• Section 3 contains details of the new reverse stress-testing requirements; • Section 4 covers other points relating to stress testing;
• Annex 1 lists all non-confidential respondents to the consultation; • Annex 2 includes detail on our revisited CBA on the new reverse
stress-testing requirements;
• Annex 3 summarises our view of good practice points in relation to building a robust stress testing infrastructure;
• Annex 4 relates to specific guidance to insurers on the Pillar 2 the capital planning stress test;
• Annex 5 includes a list of regulatory documents relating to stress testing; • Annex 6 provides a high-level overview of the components of our stress
testing framework;
• Annex 7 contains a list of acronyms used throughout this document; and • Appendix 1 contains the final Handbook text.
CONSUMERS
This paper is important for consumers because our prudential requirements and high-level standards (SYSC) for BIPRU firms and insurers are a way of achieving our consumer protection objective. Changes to these requirements therefore have
potential impact on consumers. Firms are required to undertake stress and scenario testing for risk management purposes, to assess the adequacy of financial resources and contingency plans against potential adverse circumstances.
Consultation feedback and
analysis of responses
2
2.1 This section outlines the responses received to the questions posed in CP08/24, our views on those responses and our policy decisions on how to proceed.
2.2 Firms broadly welcomed the proposals to introduce a reverse stress-testing requirement and recognised the benefits of stress testing both for firms’ senior management and for the regulator. Respondents’ support for our proposals was on the basis that reverse stress-testing requirements would be applied in an appropriate and proportionate way, which we fully intend to do. The main focus of concern was the scope of the reverse stress-testing requirement for investment firms. There was also concern about the additional costs firms could face in implementing the new requirement. We have addressed these and other issues in our analysis of responses and have narrowed the scope of the reverse stress-testing requirement for BIPRU investment firms to exclude more firms. The deferred implementation date for the new reverse stress-testing requirement for all firms is December 2010 (12 months after publication of this PS). This will ease the implementation task for firms.
2.3 Overall, there was strong support for the clarifications to our rules and guidance on stress testing that we proposed in CP08/24 and we have adopted the consultation proposal with a few minor changes. However, we acknowledge that in some areas, including pension obligation risk, firms would welcome further clarity on our
expectations and approach. Work in these areas continues and our further thinking will be communicated to firms in 2010. Although generally supportive of the clarifications we proposed, respondents also requested additional guidance from us on elements of Pillar 2 stress testing including the ‘appropriate severity’ of scenarios used for the capital planning stress. With specific reference to ‘appropriate severity’, we have adapted the proposed Handbook language to give firms a fuller explanation of our expectations, which require them to take a more forward-looking and less historical approach to identifying severe scenarios.
Market failure analysis
2.4 CP08/24 proposed changes to the current Handbook rules and guidance on stress and scenario testing. A market failure analysis was provided identifying the key role that stress testing should play in the prudential risk management of a firm. Where stress testing failed to consider the extent and the dynamic effects of changes in the external environment, the result was:
• the failure of some firms who pursued business plans that became unsustainable as wider market and economic conditions changed; and
• the need for a number of financial firms to raise additional capital at a time of low market confidence and the difficulties and increased costs that some experienced (leading in some cases to government intervention to provide additional capital). 2.5 We asked:
Q1:
What is your view of our analysis of the market failures?
2.6 Respondents agreed with our analysis that improved stress and scenario testing arrangements at firms would help to reduce the probability of firms failing, and the consequent impact and wider costs of any financial failure. They understood the need for more regulatory requirements in this area, particularly given the widespread public and political concern arising from the recent market turbulence.
2.7 However, respondents stated that, while our general analysis of market failures in the banking sector was appropriate, stress testing was only one weakness that contributed to those failures. More fundamentally, they considered that inadequate risk
management, especially credit risk management and a short-term outlook influenced by inappropriate remuneration structures were the major causes of current problems. 2.8 Some respondents commented that the market failures identified in CP08/24 appeared to be focused on the banking sector, particularly when referring to the failure of firms that pursued business plans that became unsustainable as market and economic changes took place, and the need for some firms to raise additional capital. They suggested that a more detailed market failure analysis should be undertaken in order to fully justify the proposals as they would apply to the insurance sector.
2.9 Respondents also noted that firms have been carrying out stress testing for many years (although not a reverse stress-test of the type proposed) and that this is already an integral part of the ICAAP/ICAS process for many firms.
2.10 One respondent suggested that our commentary appeared to be directed at proprietary organisations rather than mutual organisations. Two respondents suggested that some smaller organisations are less complex and more conservative in their risk appetite and proposed that a minimum size be identified below which stress testing would not be required.
Our response: Developing our stress testing policy is one aspect of our regulatory response to the financial crisis that began in 2007.
While the impact of poor stress testing has been most observable in banks, insurers have also found themselves under pressure from recent market and economic conditions. The feedback provided to insurers in the Insurance Sector Briefing: Risk & Capital Management Update (September 2008) was referred to in CP08/24. So we maintain that improvements in stress and scenario testing are needed across a range of financial institutions to help ensure that our consumer protection and market confidence objectives are met. Respondents support strengthening stress and scenario testing by building on and improving established practices. At the same time, it is important that application of the approach should be proportionate. This means that our requirements should reflect the nature, scale and complexity of the firms we regulate and the risks that they run. The specific requirements need to recognise relevant differences:
• in the nature of the businesses of banks, building societies, insurers and investment firms and the risks that they bear;
• between proprietary and mutual firms;
• between firms doing new business and those in run-off (for example, stress testing for run-off insurers is likely to be relevant mainly in the context of any restructuring of the firm, or as part of capital planning);
• between firms with simple risks and those with complex risks; and • between risk appetites of firms.
However, as the size of the firm is not necessarily an indication of a firm’s complexity or the risks that they bear, we do not propose to introduce a minimum limit to our stress testing requirements for banks or insurers. We have decided on some more specific limits in relation to reverse stress-testing, which have narrowed the scope of its application. These are outlined in our response to question five.
Cost-benefit analysis (CBA)
2.11 CP08/24 included a CBA of both the introduction of the reverse stress-test and of the proposals clarifying our existing Pillar 1 for BIPRU firms and Pillar 2 stress testing policy for BIPRU firms and insurers.
2.12 The CBA in CP08/24 was conducted under the assumption that the scope of the reverse stress-test would extend to all banks, building societies and insurers and all BIPRU investment firms excluding BIPRU 50k firms with less than £1bn of funds under management.
2.13 We asked:
2.14 Although respondents broadly recognised the need for robust stress and scenario testing, many considered that the additional requirements and increased supervisory focus would result in additional costs for firms, and suggested that our cost estimates were understated.
2.15 Respondents were also concerned that, in addition to the initial costs of setting up the reverse stress-tests, there would also be high annual costs in performing the tests and danger of multiple reworking, as had been experienced with the current ICAS/ICAAP processes, which could lead to much higher continuing costs.
2.16 Some insurance firms in particular considered, despite the result of our pre-consultation survey, that the cost of reverse stress-testing would be greater than estimated. Several respondents cited costs of additional actuarial resource as the reason for this. The need for external consultants in this field and the complexity of stress testing at the group rather than solo level could, they suggested, also give rise to additional costs for insurance groups.
2.17 Insurers also expressed concerns about introducing the requirement in 2009, as they focus on the development of models ahead of the implementation of Solvency 2. They questioned whether the benefits of the proposals for insurers would outweigh the costs and suggested that a more robust and detailed analysis of the benefits be undertaken. 2.18 One respondent was concerned that the costs were understated for smaller friendly
societies, noting that the average cost for small and medium-sized firms would be the same, so that the burden would appear to be proportionately greater for the smaller organisations. They suggested that a key aspect for the smaller friendly societies would be that reverse stress-testing would need to be largely outsourced to skilled staff. Policyholders of friendly societies, which are member owned, would be directly impacted by the costs and benefits.
Our response: We acknowledge the concerns regarding the initial and continuing costs arising from implementation of the reverse stress-testing requirement, particularly given resource pressures on firms from other regulatory requirements.
We accept that it will take time for firms to develop the skills and processes required for reverse stress-testing and that there may be additional costs during the introductory phase. However, the 12-month implementation period of the reverse-stress testing
requirement should give firms time to plan their implementation and enable them to raise questions with us to ensure that our requirements are properly understood. Firms should note that in Section 3 of this PS, we have included practical information and further assistance to firms to clarify our requirements and expectations. In particular, reverse stress-testing may initially have a strong qualitative element with a focus on
identification of the types of scenarios that could cause a firm’s business model to fail and we accept that more quantitative elements of reverse stress-testing may need to be developed over a longer period.
Nonetheless, in light of the responses received to the consultation, we have decided to: • revise the scope of the reverse stress-test by reducing the number of BIPRU
investment firms subject to this requirement and revisit the corresponding compliance cost estimates; and
• reconfirm our compliance cost estimates with some consultancy firms that review, develop and implement firms’ reverse stress-testing methodologies.
Consequently, we have revised our CBA (see Annex 2). The new analysis concludes that: • total compliance costs for investment firms are now lower due to the narrower scope
of the reverse stress-testing requirements;
• our previous estimates were broadly correct and, subject to the relevant caveats, provide a useful indication of the costs arising from reverse stress-testing; and • the 12-month implementation period should give firms valuable time to develop,
update and implement their models, and recruit and train staff.
Reverse stress-testing of a firm’s business model vulnerabilities
2.19 The reverse stress-testing requirement proposed in CP08/24 would for the first time require a firm to identify explicitly and assess the scenarios most likely to render its business model unviable.
2.20 A firm’s business model was 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.
2.21 CP08/24 stated 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. 2.22 We asked:
Q3:
Do you consider our reverse stress-testing
proposal reasonable?
2.23 Respondents generally considered that, subject to cost considerations, the reverse stress-testing proposal was a reasonable requirement that could be undertaken in an appropriate and proportionate way and readily adapted to changing conditions. They suggested this would lead to useful additional information for management and improve contingency planning and management of business failure. However, there were some reservations about the practical application of the proposal in CP08/24. These included: the use of the reverse stress-test as a risk management tool; the ‘probability’ of a reverse stress-test scenario arising in practice and the implications for a firm’s capital needs; the interaction of reverse stress-testing with a firm’s risk appetite/tolerance; and the level (group or solo) at which the reverse stress-test should be undertaken.
Risk-management tool
2.24 A number of respondents commented on the use of the reverse stress-test as a risk-management tool. Respondents generally saw the risk management benefits of the proposed requirements. The key benefits outlined by respondents included: • 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.
2.25 Some respondents suggested that we should encourage the management bodies of firms to increase their focus on scenario development and analysis. The rationale was that such a requirement would involve management bodies thinking through a range of extreme scenarios, potential mitigants and trigger points for action that would lead them to focus on big issues rather than detailed sets of numbers. The involvement of non-executive directors, to ensure senior management take an appropriately broad view and pay due attention to extreme scenarios, was also advocated.
2.26 There were, however, some concerns that the benefits of reverse stress-testing might not be realised if it were implemented inappropriately, for example if:
• reverse stress-testing added another layer of complexity to the detailed information already available from firms’ Pillar 2 modelling and detracted from a longer-term commercial view;
• the gains expected were from the narrative and thought process of the reverse-stress scenarios, rather than from the numerical analysis that may be required, there would be a danger of firms becoming bogged down in the financial analysis. This would overlook the real benefit from considering appropriate mitigations and process changes;
• reverse stress-testing normally resulted in a requirement for additional capital. • if the FSA, rather than a firm’s management, specified the situations likely to lead
to the failure of its business model that a firm should use; and
• if detailed rules on reverse stress-testing diverted insurers’ resources away from planning to implement Solvency 2 by 2012.
2.27 Clarification was also sought on why the reverse stress-test should apply to insurers already in run-off. Both Pillar 1 and Pillar 2 already require the costs involved in closing the fund and running off the liabilities to be considered, if this provides a higher capital requirement than on a going concern basis.
Reverse stress-test scenarios and impact on capital requirements
2.28 A number of respondents queried the sorts of scenarios that firms should consider under reverse stress-tests and expressed concern about the potential links between reverse stress-testing and capital needs. These concerns were highlighted despite CP08/24 stating
that the reverse stress-test did not mean we were pursuing a ‘zero-failure’ approach. Reverse stress-testing was proposed to be added to SYSC, recognising its importance as a risk management requirement, and not as a means of determining capital requirements. 2.29 The key issues raised were whether the scenarios should be ‘plausible’ and whether
the results of the reverse stress-test would be used by supervisors to set individual guidance. In particular, concern was expressed that supervisors might set individual capital or liquidity guidance requiring a firm to have capital or liquidity sufficient to mitigate the impact of the reverse stress-test scenario. Respondents suggested that such an approach would be likely to lead to firms not considering scenarios that imply significant erosion of capital, as this would increase the individual capital guidance set by supervisors, who might view the consequences of the scenario as a risk to our statutory objectives. Respondents therefore sought clarity about how the results of the reverse stress-test would be used in setting individual capital guidance (ICG), when considered alongside ICAAP/ICAS and ARROW.
2.30 In order to avoid such outcomes, respondents suggested that we should state that firms undertaking a reverse stress-test should consider ‘plausible’ rather than ‘remote’ scenarios and that the Handbook text should be amended to reflect this. Respondents provided a range of justifications for their thinking, including concerns that firms may find it difficult to consider hypothetical remote scenarios or that remote scenarios may not provide much insight in terms of risk management.
2.31 One respondent commented that not all failure events are driven by lack of capital, as significant operational risks or changes in market perception, for example, could cause a firm to fail. They suggested that the text should be altered to address this.
Terminology
2.32 One respondent suggested that the term ‘reverse stress-testing’ should be included in the Handbook Glossary. Alternative suggestions to our proposed terminology included ‘business model stress test’.
Risk appetite
2.33 A number of respondents commented on the Handbook text provision requiring a firm to put in place risk mitigation where a reverse stress-test reveals ‘a risk of business failure inconsistent with the firm’s risk appetite’ (SYSC 19.1.5R (2) in the draft Handbook text in CP08/24). The main point raised was that some firms considered business failure, by definition, as being outside their risk appetite.
2.34 One respondent noted that the reverse stress-test could reveal two types of risk that could lead to business failure:
• first, those risks that are inconsistent with risk appetite and need to be mitigated; and • second, risks that are so remote they are consistent with the firm’s risk appetite. 2.35 It was suggested that SYSC 19.1.9G in CP08/24 should focus on the less remote risks,
requiring firms to develop risk mitigation programmes for the risks of the first type and to state reasons for accepting risks of the second type.
2.36 A further comment was that the proposed rules implied that a firm with a low risk appetite would be required to take action before a firm with a high risk appetite. The respondent considered that regulatory requirements should not depend on a firm’s risk appetite. They suggested that reference should be made to a firm taking action when the tests show an unacceptably high level of risk in absolute terms.
Level of the reverse stress-test: group versus solo
2.37 Some respondents expressed a preference for the reverse stress-test to be conducted at group level. This was because the costs involved in conducting additional reverse stress-testing at a more granular level (business unit or solo regulated entity level) would be considerably higher and the benefits of doing so are unclear as they would depend upon the firm’s organisational and legal structure.
2.38 Conversely, there were concerns from one respondent about the difficulty in practice for global financial firms in identifying scenarios where business plans become unviable given their many different, long-term risk exposures that may have complex correlations. There could be a significant number of scenarios that could cause the current business plan to become unviable and considering management actions for multiple scenarios would be demanding. The respondent suggested that the main benefit from the exercise would result from the thinking behind the scenarios rather than their modelling. There was also concern that undue focus on such scenarios may divert attention away from longer-term commercial strategies and investments.
2.39 In addition, for firms operating internationally, respondents raised potential
jurisdictional issues concerning interaction with non-UK parents. Some firms suggested that the highest-level entity in the UK be the focus of the reverse stress-test required by the FSA if the parent company were outside the UK. Respondents’ preference would be for firms to be able to decide for themselves, on a discretionary basis, how much reverse stress-testing was undertaken at the solo level, business level or group level, with clear Handbook guidance about the minimum standards that apply.
2.40 Some respondents also argued that compliance with the guidance set out in
SYSC 19.1.8G (2) in CP08/24 (indicating that we may request firms to quantify the impact on financial resources that would place a firm in situation of business failure) would be unlikely to be possible or meaningful for a subsidiary. Respondents
suggested that it is not clear what level of capital resources would constitute business failure, as external counterparties generally look to the level of capitalisation of the group rather than of the individual subsidiary, particularly where the entity benefits from a parental guarantee.
Our response: In view of the general support for our proposal, we are introducing requirements for reverse stress-testing as part of the suite of stress testing that firms are required to undertake. At the same time we are clarifying our requirements, to address concerns arising in the consultation. As noted above, we are allowing a period of 12 months before our reverse stress-testing requirements come fully into force.
5 This view is reinforced in A review of corporate governance in UK banks and other financial industry entities (2009) by Sir David Walker which states that ‘Within the context of stress testing, the board risk committee and board should understand the circumstances under which the entity would fail and be satisfied with the level of risk mitigation that is built in.’
Risk management tool
The purpose of the reverse stress-test is to identify and consider scenarios that would lead to a firm’s business model becoming unviable. Our view is that this is an important complement to the suite of stress tests that firms are required to carry out. However, we are clear that 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. Supervisors are likely to review a firm’s reverse stress-tests as part of the ARROW risk assessment and alongside the firm’s ICAAP/ICAS, and will regard reverse stress-testing as a complement to these processes. We agree that an important benefit of reverse stress-testing is the thinking behind the scenarios. Our requirement is expected to encourage improved understanding of risks throughout an organisation, especially at senior levels. This should help to 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. It is not intended to distract the attention of management from making commercial decisions, but rather to help ensure that regulated firms are sufficiently robust in changing conditions. We also consider the term ‘reverse stress-test’ to be appropriate. Such stress testing starts from an outcome (i.e. failure of the business) and identifies circumstances in which this may occur, rather than testing for outcomes arising from changes in circumstances of different likelihoods.
As with other aspects of risk management, reverse stress-testing should be implemented proportionately. So, for example, smaller and less complex organisations would be expected to conduct less complicated reverse stress-testing, possibly more qualitative than quantitative, but larger and more complex organisations will need to conduct more extensive stress testing, which will be both qualitative and quantitative in nature.
Reverse stress-testing scenarios and impact on capital requirements
As stated in CP08/24 and above, reverse stress-testing should not be interpreted as introducing a ‘zero-failure’ regime or a means of directly increasing firms’ capital requirements. It is essential that firms identify the prospective drivers of failure and use this information to ensure that the relevant risks are sufficiently well-understood and appropriately managed to secure consumer protection and market confidence.5
However, reverse stress-testing may result indirectly in changes to the levels of capital held by firms. For example, if a firm’s reverse stress-testing identifies business model vulnerabilities that have not previously been considered, but which the firm expects to survive according to its risk appetite/tolerance, the firm may decide to take mitigating action or hold a different amount of capital.
We agree that not all business failure is driven by lack of capital although this is one factor that should be considered.
6 This is consistent with statements made in relation to supervision of groups set out in DP09/2 A regulatory response to the global banking crisis which accompanied The Turner Review (March 2009).
Risk appetite
We note respondents’ comments about the link between a firm’s risk appetite and the risk of business failure. Reverse stress-testing is designed to identify issues, such as risk concentrations, that may affect the alignment of a firm’s business strategy and its risk appetite, by requiring the firm to consider scenarios that would cause its business model to fail. In undertaking reverse stress-testing, each firm should consider and document the interaction between business failure and its stated risk appetite.
Firms should carefully analyse and review reverse stress-testing outcomes in the context of their risk appetite. This is to ensure that where risk factors are identified in reverse stress-testing that could cause business failure and they are considered sufficiently remote so that they are consistent with the firm’s risk appetite, senior management are able to demonstrate this through the outputs of the reverse stress-test. This should enable senior management to justify why no mitigating action is required against these risk factors. Equally, firms may identify risk factors causing business failure that are inconsistent with the firm’s risk appetite. That is, the situation may be sufficiently probable that the firm will expect to survive this event. In such cases, we would expect firms to take mitigating action to ensure that its risk appetite is consistent with reverse stress-testing outcomes.
Level of the reverse stress-test: group versus solo
We have concluded that, for a firm that is a member of a group (including insurance groups that are required to maintain group capital), a UK consolidation group or a non-EEA sub-group, the reverse stress-test must be carried out on a solo basis for the firm as well as on a consolidated basis for the group.6 As we stated in CP08/24, scenarios that constitute business failure for a firm may differ from those that may constitute failure for a group of which it is a member. Whereas the failure of a group is quite likely to be accompanied by the failure of a member firm, the converse may not necessarily be true. Different groups may also differ in the extent to which they are prepared to support a member if the member experiences financial difficulty.
Therefore, a combination of top-down and bottom-up approaches is appropriate. This, we believe, will lead to a more complete understanding of the events and circumstances that would break a firm’s business.
However, consistent with our principal of proportionality for applying the reverse
stress-testing requirements, where solo entities are immaterial in a group structure, and their going concern status can be shown to depend primarily on the solvency of the group, the solo reverse stress-test is likely to simply be a function of the group reverse stress-test. In such circumstances, a simple qualitative submission from the solo entity pointing to the group stress test, would suffice. Conversely, an effective group stress test should include risks emanating from all material solo entities whether domiciled in the UK or abroad.
2.41 We asked:
Q4:
To what extent are firms already undertaking
reverse stress-tests? What is the involvement
of senior management in the design and review
of these tests? What further steps would firms need
to undertake to carry out a reverse stress-test as
outlined in these proposals?
2.42 Respondents’ feedback suggests most firms do not currently undertake reverse stress-testing in the form proposed.
Banks
2.43 A small number of banks (according to the British Bankers Association) undertake reverse stress-tests, although it is not clear if their practice is in line with our proposals. 2.44 One respondent did not support a requirement that the test be signed-off by the firm’s
board, arguing that this would involve the board in operational management of the bank, which is not in line with typical governance structures. It was suggested that stress testing processes and scenarios should be reviewed by appropriate executives appointed by senior management, with scenario approval by a committee which is delegated authority by the Board.
Insurers
2.45 Most insurers undertake a variety of stresses through the ICAS process that are overseen by senior management. That process sets no specific reverse stress-test requirement but a few insurance firms have undertaken some work to introduce similar requirements in their business to strengthen their stress testing framework. One respondent, however, suggested that reverse stress-testing may have little additional benefit in the short term due to the variety of stress tests already undertaken.
2.46 One respondent considered that it will take several years for the industry to build reverse stress-tests that are fully integrated and advised that we should be careful to ensure that sufficient time is allowed for these to evolve and remain proportionate in their application and supervision. Early analysis would necessarily be an iterative process given the subjectivity and sensitivities involved.
2.47 Respondents also emphasised the need for significant review of all existing risks by senior management in order to perform reverse stress-tests and suggested that firms may require third party consulting support to do this.
Investment firms
2.48 Investment firms do not uniformly carry out reverse stress-tests as stated in CP08/24. However, we note that many have a good understanding of their business models and are experienced in managing key risks during difficult economic conditions. Investment firms also tend to undertake an analysis of orderly wind down, which identifies the issues and costs involved when a business model fails.
Our response: We welcome early moves by firms to develop and incorporate reverse stress-tests as proposed in CP08/24.
Having the test signed-off by the firm’s board is essential to ensuring senior management engagement. We accept that firms will implement various governance structures, but the framework should ensure thorough challenges and regular review processes by senior management and others, so that reverse stress-testing is meaningful for the organisation. We acknowledge that the reverse stress-test may be a new concept for many firms. With this in mind, the proposed timetable for reverse stress-testing is full implementation 12 months after publication of this PS. Before this, we will ask firms to put together an implementation plan that details the steps they will take to meet the implementation deadline. We will ask firms to send their completed plan to us for review by June 2010. Please see Section 3 for more information on the implementation of the reverse stress-test.
Insurers
We recognise that insurers already undertake a wide range of stress tests and are encouraged that firms have strengthened their stress and scenario testing further and have plans to introduce reverse stress-testing.
Proportionality in reverse stress-testing
We note the comments received in response to question two about the potential cost of undertaking reverse stress-testing. We are also aware that a wide range of firms will be required to undertake reverse stress-testing.
We understand that it will take some time for the process to develop and this will be reflected in our supervisory approach. We will be correspondingly proportionate in assessment of firms’ reverse stress-testing. We will focus on the outcomes in terms of identifying factors that could lead a firm’s business model to fail and how this interacts with a firm’s strategy and risk appetite/tolerance.
For smaller, simpler firms, reverse stress-testing may primarily be an exercise in senior management judgement focused on scenario selection. For very small firms the submission may be a short written explanation of these factors, which would simply need to be periodically refreshed. It does not necessarily involve detailed modelling. For larger, more complex firms, a more structured and comprehensive approach to reverse stress-testing is expected, in line with our general requirements for firms’ stress testing infrastructure as outlined in Annex 3. However, even for larger firms we will take a staged approach to our assessment of reverse stress-testing. That is, as reverse stress-testing is introduced, it may at first have a strong qualitative bias with a focus on identification of the types of scenarios that could cause a firm’s business model to fail. We accept that more quantitative elements of reverse stress-testing may have to be introduced over a longer time period. Such phasing will be subject to discussion between firms and their supervisors, with reverse stress-testing being meaningful from the outset.
7 Please note that this explicit reference to assets under administration is included to clarify what we implicitly meant when talking of “assets under management” in CP08/24.
2.49 We asked:
Q5:
Is it appropriate to exclude BIPRU 50K investment
firms from the reverse stress-testing requirements if
wind-down scenarios are an important part of their risk
analysis? Given that our expectations would be based
on a proportionate approach by smaller firms, would
reverse stress-testing be resource intensive for BIPRU
50K investment firms?
2.50 In general, there was no real objection from banks, building societies or insurers on the topic of the scope of the reverse stress-test.
BIPRU investment firms
2.51 However, investment firms did express concerns on scope – specifically that the exclusion from reverse stress-testing did not extend to all limited licence firms. Respondents felt that this was not a proportionate approach and that the threshold criteria to determine which investment firms would be in scope were too arbitrary. 2.52 Some firms wanted the proposed exclusions to apply to all limited licence firms,
including BIPRU 125K firms, as they argued that conduct of business requirements would be a more appropriate risk mitigant than capital.
Our response: We note investment firms’ concerns about the scope of the reverse stress-testing requirement and the need for us to take a proportionate approach. We also believe that our proposals should take account of our existing requirements to avoid duplication of effort. In particular, some investment firms are required to undertake an analysis of orderly wind down which other BIPRU and INSPRU firms are not required to do. Therefore, we have reviewed the proposals set out in CP08/24 and amended the scope of the reverse stress-testing requirement as it applies to BIPRU investment firms.
BIPRU investment firms will be excluded from the reverse stress-testing requirement if they have:
• where they carry out the regulated activity of managing investments or safeguarding and administrating investments, assets under management or administration7of no more than £10bn (or the equivalent amount in foreign currency);
• total annual fee and commission income arising from its regulated activities of no more than £250m (or the equivalent amount in foreign currency); or
• assets and liabilities of no more than £2bn (or the equivalent amount in foreign currency). We accept this is itself a relatively arbitrary cut-off measure but we believe it is set at a sufficiently high level to capture the larger, more complex firms.
In order to determine whether a BIPRU investment firm is excluded from the reverse stress-testing requirement, the exclusion criteria (above) will apply on a consolidated basis to all of the BIPRU investment firms within the same UK consolidation group or non-EEA sub-group as if they were one firm.
We will write to those investment firms which, under the new criteria, we consider to be in-scope of our reverse stress-testing requirements. We will do this in the first quarter of 2010.
As an additional safeguard measure, if an investment firm satisfies one of the above criteria in any given year, it will be required to comply with the reverse stress-testing requirement for that year and the following two years, whether or not it continues to meet the criteria. In addition, supervisors may ask certain excluded firms to undertake a reverse stress-test if they believe that it would be valuable for the firm to do so.
Our revised approach will result in more firms being out of scope than under our previous proposals and we believe that this represents an objective and proportionate approach. This segmentation, however, will be kept under review and we would recommend that the senior management of out-of-scope firms consider the use of reverse stress-testing in managing the risks of their business.
Clarification of Pillar 1 stress testing policy
2.53 We asked:
Q6:
Do you agree with our proposed clarification of the use
of stress testing in IRB quantification?
BIPRU firms
2.54 We sought to clarify that the purpose of the stress testing IRB requirements in BIPRU 4.3.39, which were copied out from language in the CRD and the Basel text, was to aid calibration and/or validation of IRB estimates; and provided high-level guidance around how this should be carried out.
2.55 Most respondents supported our proposal. However, the response from the main industry associations raised some reservations. These included:
• an argument that IRB parameterisation and stress testing are two distinct processes that should not be mixed; and
• stress testing would produce overly conservative estimates that would be inconsistent with the required calibration of the IRB parameters – for example, ‘long-run average default rates’ – or the requirement for estimates not to be based purely on judgemental considerations.
Our response: We agree with respondents that it would be inappropriate to use highly-stressed inputs where the IRB requirements call for averages, and also that estimates based purely on judgement are not acceptable. However, it is also inadequate to use as IRB estimates simple calculations of past parameters without considering whether this might be an incorrect estimate of what the parameter will be in the future – the latter being the target of IRB quantification. So, a properly-specified IRB approach requires a
mix of historical data and judgemental adjustment. The inherent difficulty in this process means that accuracy is very challenging to achieve and the language in BIPRU (4.3.88), which is copied out from the CRD, clearly states that ‘a firm must add to its estimates a margin of conservatism that is related to the expected range of estimation errors.’
Since initial publication of the IRB standards, industry has asked how the IRB stress testing requirement differed from the more general stress testing requirements in Pillar 2 and the specific IRB cyclicality stress test. The potential for stress testing to be used to investigate how parameters might differ from the historical data has been discussed for some time. For example, the Basel Committee’s 2005 guidance on loss given default (LGD) estimation highlighted the potential for stress testing calculations to assess the robustness of LGD estimates.
We therefore intend to retain the Handbook language proposed in CP08/24 with the exception of a change to the terminology used to describe appropriate severity in the cyclicality stress testing requirement in BIPRU 4.3.40R(2) which is linked with the Pillar 2 stress test. In response to respondents’ concerns about our use of the term ‘one in 25 years’ to describe the appropriate severity of stress tests under Pillar 2, we are removing this language from our Handbook text to provide a more comprehensive definition of our expectations in this respect. Consistent with this we have amended the language in the cyclicality stress testing requirement in BIPRU 4.3.40R(2).
Credit risk mitigation
2.56 We asked:
Q7:
Do you agree with our proposed clarification of the use
of stress testing for credit risk mitigation purposes?
2.57 Most respondents supported our clarification of the use of stress testing for credit risk mitigation purposes. However, respondents also considered that stress testing for credit risk mitigation should only be applied if the risk is material and not already covered by other assessments. It was noted, for example, that GENPRU 1.2.42 already requires stress testing of residual risk. It was also pointed out that some mitigants could fail in stressed circumstances.
Our response: The aim of the proposed clarifications was to make clear that all risks associated with credit risk mitigation should be considered in stressed circumstances, including in relation to the value of the mitigation. We considered this to be insufficiently clear in the Handbook text proposed in CP08/24.
Our response to questions raised about materiality is that we expect firms to be able to demonstrate to us, at an appropriate level of detail, why they consider a particular risk is not material and need not be stressed.
We agree with respondents that some mitigants may fail in whole or part under stressed circumstances and it is vital that firms should identify these scenarios and respond accordingly.
Operational risk
2.58 We asked:
Q8:
Do you agree with our perception of the role of stress
testing in operational risk and our proposal not to
prescribe any additional stress testing requirements
specifically for operational risk?
2.59 All respondents agreed with our current level of stress testing requirements for operational risk and considered that there was no need to extend them. There was also a general understanding that assessment and management of operational risk should be proportionate to the nature, scale and complexity of each individual firm, so imposing supplementary requirements would not be appropriate for all businesses. 2.60 Some firms suggested that we should offer additional support in identifying
boundary events and scenarios to be evaluated to help firms to be better prepared for potential events.
Our response: All BIPRU firms are required to have effective processes to identify, manage, monitor and report the operational risks to which they may be exposed. We expect these to be proportionate to the nature, scale and complexity of the firm’s activities and the use of scenarios will aid this requirement. We generally expect this practice to be in use among large complex firms. In addition, firms using the Advanced Measurement Approach for operational risk may use scenarios for the quantification of the operational risk capital requirement and/or as a check on the inputs, outputs and accuracy of risk models. We will not prescribe scenarios for operational risk as we consider it more valuable if each firm identifies its own risk profile, as this will improve its understanding of its individual risks and the best way to mitigate them.
When we discuss the use of scenario analysis and stress testing of operational risks with firms, we expect a firm in its use of these techniques to have taken full account of the GENPRU and BIPRU requirements and, in particular, to carry out stress and scenario testing that is appropriate given the firm’s potential risks. In addition, a firm undertaking stress and scenario testing should determine the impact and frequency of a stress event as well as the controls and mitigants that will be used in the risk management process.
All stress and scenario testing processes should be comprehensively documented, which includes recording the scenarios and stresses applied as well as the risk management options, outcomes and actions taken.
Handbook changes to clarify Pillar 2 stress testing policy
2.61 Pillar 2 is one of three ‘supervisory Pillars’ that form the framework for prudential supervision of capital management by banks, credit institutions, investment firms and insurers. Within the overall framework, Pillar 2 specifically requires firms to assess the amount of internal capital they consider adequate to cover risks that they are, or may reasonably expect to be, exposed to. A key element of Pillar 2 is a capital planning
8 A cycle-neutral position describes an average point through the economic cycle.
stress test to understand how changes in the external environment will affect firms’ ability to meet their capital needs, including minimum regulatory capital requirements, on a forward-looking basis.
2.62 In CP08/24 we proposed amendments to our Handbook text to make it clearer that to comply with the overall Pillar 2 rule as set out in GENPRU 1.2.30, firms must satisfy the general stress testing requirement set out in GENPRU 1.2.42R.
2.63 We proposed inclusion of additional text in order to provide additional guidance to firms on stress and scenario testing including clarity on appropriate mitigating management actions, severity of stresses and consideration of how risks may combine. 2.64 We also sought to clarify our expectation that, in general, BIPRU firms should hold
sufficient capital now to meet their overall financial adequacy rule (GENPRU 1.2.26R) in the face of a stress scenario, after allowing for realistic management actions. 2.65 We asked:
Q9:
Do you have any comments on the proposed changes
to the general stress and scenario testing rule and
additional guidance to firms?
2.66 The industry response to the question on our general stress testing requirements under Pillar 2 was largely favourable, as respondents welcomed the proposed additional guidance. We are taking the opportunity in this document to comment fully on the extensive responses received.
2.67 Generally, respondents suggested a need for further guidance or clarification. Firms, especially larger, more complex firms, were keen to understand more about the severity of stress that we view as appropriate for the capital planning stress test and to understand better our approach to combining a sudden market-type shock with longer-term economic decline. The terminology proposed in CP08/24 of a ‘one in 25 years event’ was also questioned in terms of clarity and whether it referred to historical experience or not. Respondents also queried whether expected severity would move further out in a cyclical downturn or whether the severity of the scenario is supposed to be defined from a cycle-neutral position.8
2.68 Respondents considered that it was important for our stress and scenario testing requirements to be applied proportionately, i.e. having regard to the nature, scale and complexity of the risks borne by firms as well as being aligned to the risk appetite of the firm. In particular, they considered that appropriate recognition should be given to differences in the nature of banking and insurance businesses and between proprietary and mutual organisations. They also considered that we should be proportionate in our review and challenge of the stress and scenario testing performed by a firm. 2.69 Some respondents suggested that more prescriptive guidance from supervisors, such as a
range of commonly prescribed scenarios and guidance on the extent to which risks should be assumed correlated in a stress situation would assist them in designing scenarios.
2.70 The extent to which we would allow the impact of management actions to mitigate a stress to be taken into account, and particularly whether group support would always be regarded as a management action, was another point on which clarification was sought.
2.71 Some respondents queried how our approach would be co-ordinated with other regulators to assist internationally-active firms in facing a consistent approach in home and host jurisdictions.
2.72 A number of participants from a wider variety of firms wanted to understand how the explanations for Pillar 2 stress testing outlined in CP08/24 fitted in with other revisions to stress testing approaches and, in particular, how the stressed value at risk (VaR) requirements envisaged in trading book amendments and the severe stress test envisaged in our enhanced liquidity regime.
2.73 One respondent considered that the statement in the proposed GENPRU 1.2.42R(3) was not clear without quantifying or stating more explicitly a confidence level/probability.
Our response: We note the broad support for our proposed changes to the general stress and scenario testing rule and the additional guidance that we incorporated into the Handbook text. To address the range of comments received to this question, and to help firms undertake better stress tests, in this section we outline:
• good practice in building an effective stress testing infrastructure;
• the appropriate severity of scenarios and how supervisory recommended scenarios can help in this regard;
• a description of how scenarios might interact with the economic cycle; • our approach to assessing the credibility of management actions; • how our requirements link with international regulatory developments; • the link with a future macro-prudential regime; and
Building an effective stress testing infrastructure
Although our proposed changes to the Handbook and additional guidance are intended as clarifications for firms in respect of stress and scenario testing, it is vital that firms take ownership and responsibility for stress and scenario testing in their organisation and fully embed it in their risk management and strategic decision-making. Our decision to use high-level requirements with supporting guidance is designed to ensure that the onus is on firms to identify their material risks and the accompanying scenarios that are appropriate for their business and risk profile.
In order for stress testing to be effective, it is important that firms undertake it properly. In Annex 3, we set out and remind firms of our expectations on the governance of stress testing, and good practice in establishing an effective stress testing infrastructure. Some of the key points highlighted in the annex are that:
• board and senior management should actively engage in stress and scenario testing, taking ownership and responsibility for establishingan effective stress testing programme and infrastructure in the firm;
• senior management should take a key role in implementingthe firm’s stress testing programme by being actively involved throughout the process, including in scenario selection;
• senior management should take actionas a result of stress testing and integrate stress testing outputs into the firm’s decision-making process;
• firms should establish a robust stress testing programme covering all relevant levels of its business, all risk types and over a range of severities; and
• firms should establish a robust stress testing infrastructure with appropriate IT systems and resources in place, which should be periodically reviewed by senior management for its continued effectiveness.
Severity of scenarios
We rearticulate here our view of the appropriate degree of severity that firms should apply in constructing stress scenarios for the Pillar 2 capital planning stress test. Firms should also note that from time to time, we may recommend scenarios to be applied directly in the ICAAP or ICAS of specific firms or that, more generally, can serve as an informative adverse scenario to guide firms’ calibration of their own scenarios, and as an indication of appropriate severity (as a result, we refer to this as an ‘anchor’ scenario). For further details, see the box below on supervisory recommended scenarios and also Annex 6. Applying an appropriate degree of severity to stress scenarios is not sufficient in itself to ensure the effectiveness of a stress test. An effective mechanism to translate macroeconomic parameters into specific effects on a firm’s risk parameters is equally important. Nonetheless, severity is important and the definition of ‘appropriate severity’ has attracted significant debate in 2009, as expectations and understanding of a ‘severe yet plausible’ scenario took account of experience through the recent market turmoil. As outlined in CP08/24, in our analysis of firms’ stress tests undertaken before that turmoil, we observed that firms did not consider sufficiently severe scenarios.
In CP08/24 we consulted on the idea of extending the BIPRU provisions, asking a firm to assess the effects of an economic recession of a severity experienced once in 25 years to the more general GENPRU 1.2.42R stress testing requirement. However, we have observed that the ‘once in 25 years’ terminology has been widely misunderstood in the following ways: • it led to a simple repetition of recent experience such as the downturn of the
early 1990s;
• it caused confusion with quantitative confidence intervals referred to in supervisory requirements; and
• in the recent downturn, claims that we are now beyond a ‘once in 25 years’ experience led to suggestions that firms did not need to undertake further stress tests (see the box below on ‘Scenarios and the economic cycle’).
Accordingly, and based on respondents’ concerns about potential misunderstanding of the ‘once in 25 years’ terminology, we intend to remove the ‘once in 25 years’ guidance from our Handbook text. Instead, we have amended various provisions in the Handbook text in accordance with the guidance set out below.
Our rearticulated guidance on severity
In their Pillar 2 capital planning, firms should consider a range of scenarios. They should include a severe downturn scenario based on forward-looking hypothetical events that are calibrated against the most adverse movements in individual risk drivers experienced over a long historical period. Our Handbook text will be amended to reflect this revised approach. For example, a firm might identify a combination of a fall in equity prices, an interest rate shock in an adverse direction and an extended downturn in GDP as relevant for its risk profile. The exact combination of these circumstances should be considered in the light of current and hypothetical circumstances including possible second-order effects. However, the severity
1952 1855 1879 18851950 1900-1 1957 1867 1832 1850 19031837 1956 1975 1926 1908 1930-1 1979-81 1944-7 1919-21 1973-4 1990-1 1892-3 1961 1840-42 2008-9 (to date) Mean of firms' Pillar 2 scenarios -25 -20 -15 -10 -5 0 Peak to t rough fall in real GDP (%)
Sources: Maddison (1830 - 1954); ONS (1955 - Q3 2009); selected major firms' ICAAPs (2008-2009)
of movements in those risk drivers should be internally consistent and calibrated to relevant long-run historical experience The graph below illustrates that simple reference to experience in the twenty five years to 2007 would not give an appropriate view of severe stress.
Our re-articulation is not designed to directly require firms to undertake a more severe stress test, but is intended to address misconceptions that arose from the ‘once in 25 years’ terminology. For example, looking at the 25-year segments preceding 2007, the worst GDP fall over any 12-month period was -1.8% whereas over a longer historical period of 175 years, the average 25-year downturn in GDP over any 12-month period was significantly more severe. We acknowledge, however, in light of recent experience that in practice firms are likely to find that their scenarios are more severe than in previous years.
We also intend to assist firms in formulating scenarios by recommending supervisory scenarios that can be applied directly in the ICAAP or ICAS in the case of specific firms or can be applied more generally as an informative adverse ‘anchor’ scenario that would serve as an indication of appropriate severity against which firms could calibrate their scenarios.
Other considerations
In addition we expect firms to consider how the chosen scenario:
• addresses all material risk types and factors relevant to the institution – this mainly means credit risk, market risk, operational risk, interest rate risk and liquidity risk as appropriate, but this is not exhaustive;
• addresses institution-specific vulnerabilities, including regional and sectoral characteristics and specific product or business-line exposures and concentrations; • considers a confluence of events and in particular, the possibility that a sharp market
shock may be followed by a prolonged period of economic decline;
-10 -5 0 5 10 15 20 25 30 1858-1882 1883-1907 1908-1932 1933-1957 1958-1982 1983-2007 Period % Unemployment Max RPI inflation Max UK Base rate Max GDP Min
• contains a scenario narrative that includes various trigger events where appropriate, which could include monetary policy, financial sector developments or triggers, such as commodity prices or even political events and natural disasters;
• is forward-looking over the same period as the ICAS/ICAAP;
• captures the most severe elements and probability of occurrence that an institution expects to survive – it should be a serious but not fatal scenario related to a firm’s stated risk appetite in a meaningful and consistent way and tested for resilience in relation to that risk appetite; and
• considers dynamic feedback effects and second-order effects of Pillar 2 risks with each other.
We have provided guidance in the Handbook in this regard but ask firms to consider the potential impact of second-order effects in their stress testing (for example, liquidity risk resulting from operational failure of a counterparty from whom the firm was expecting funds). There is a clear difference between the scenarios used for capital planning and those that are realised as a result of firms’ reverse stress-testing. However, we note that firms may find the analysis from the reverse stress testing is a useful tool in assessing the content and severity of their capital planning stress.
Supervisory recommended scenarios
While the responsibility for scenario selection should rest with firms’ senior management, our experience during the recent crisis has been that there is value in assisting firms through the identification of supervisory recommended scenarios as a complement to firms’ own scenarios. In this context we noted respondents’ feedback in relation to the merits of scenarios recommended or set by supervisors. We remain cautious about prescribing scenarios through the Handbook but do see a role for us to recommend scenarios to firms from time to time. We have added guidance in relation to this in GENPRU 1.2.73BG. Setting a supervisory recommended scenario will involve the formulation of macroeconomic and/or financial market scenarios. We intend to publish the high level parameters of our recommended scenarios externally.
We are mindful that introducing supervisory recommended scenarios requires taking a proportionate approach, particularly taking into account that different types of firm are exposed to and affected by different risks. One way of accounting for these differences is for supervisors to formulate a macroeconomic scenario that reflects relevant supervisory concerns. Generally we would expect firms to use this scenario as an adverse ‘anchor’ in the development of their scenarios. The adverse ‘anchor’ scenario could then be used as the basis for firms to create their own scenario that tests firm-specific vulnerabilities and that is appropriate and consistent with their individual types of business.
In some cases we may require specific firms to run this scenario directly as an input to their ICAAP/ICAS. It may also be the case that we run our own supervisory stress testing in addition to firms’ stress testing. Where the FSA undertakes its own stress testing analysis using these scenarios, we will use our results to assess firms against minimum specified capital levels.
