This checklist outlines why stress testing and scenario analysis are important for companies that need to comply with financial regulations.
Stress testing generally refers to examining how a company’s finances respond to an extreme scenario. The stress-testing process is important for prudent business management, as it looks at the “what if” scenarios companies need to explore to determine their vulnerabilities. Since the early 1990s, catastrophe modeling, which is a form of scenario analysis for providing insight into the magnitude and probabilities of potential business disasters, has become increasingly sophisticated. Regulators globally are increasingly encouraging the use of stress testing to evaluate capital adequacy. As financial products, markets, and regulations become increasingly complex, the challenges for treasurers, supervisors, bankers, and regulators become ever greater in trying to keep up with the risks. Business leaders must ensure that the risk management and control framework within their businesses can keep up with changes in markets, financial instruments, business models, and regulation in order to help protect their long-term sustainability and profitability. There have been calls—likely to be heeded—for even more strengthening of regulation in areas such as off-balance sheet risk, liquidity and funding risk, and incremental trading risk.
There have also been calls for improved stress testing and scenario analysis, particularly in the wake of the 2008 banking crisis when it became clear quickly that something had gone badly wrong with the banks’ stress-testing regimes. Although financial institutions monitor and forecast for various risks—operational, market, and credit, as well as sensitivity analysis—to determine how much capital they should hold, it seems that many of them ignored the risks of overextended credit in this case.
When new regulations are brought into play, financial institutions adapt themselves, but adaptation is not the only way forward. They must learn how to best use the data that they already possess to enable them to embrace regulatory change without seeing it as a burden. Although companies seek to increase reliability and profitability, and regulation can be a drain on costs, the seamless integration of risk management processes and tools—which includes stress testing and scenario analysis—should give them a competitive advantage and enable them to become more sustainable.
Ongoing business planning is dependent on accurate forecasting. Without good stress testing and scenario analysis, big corporations cannot make accurate business forecasts. One approach is to view the business from a portfolio perspective, with capital management, liquidity management, and financial performance integrated into the process. Comprehensive stress testing and scenario analysis must take into account all risk factors, including credit, market, liquidity, operational, funding, interest, foreign exchange, and trading risks. To these must be added operational risks due to inadequate systems and controls, insurance risk (including catastrophes), business risk factors (including interest rate, securitization, and residual risks), concentration risk, high-impact low-probability events, and cyclicality and capital planning.
Senior management needs to be involved in the development of scenarios that could affect their business and, in some cases, the economy as a whole. Accurate analysis of business strategies is critical for compliance with regulation and improving performance. When both these goals are achieved, adapting the company for regulatory compliance can be seen as an opportunity for competitive advantage.
There are no real disadvantages to performing stress testing and scenario analysis. However, it can be very expensive, which may be a deterrent to using them.
Include stress testing and scenario analysis in your business planning every year, or even every quarter, or more often if the situation changes enough to justify it.
Investigate software options that can help predict scenario outcomes.
Dos and Don’ts
Employ external specialists to conduct stress testing if your company is not big enough to justify an internal department for this purpose.
Keep asking “what if?”
Don’t ignore the need to perform these analyses.