Our client wanted to implement a stress testing and scenario analysis framework in order to identify and analyse current and potential issues that were of market-wide concern or that could affect them, and even in extreme cases threaten their ongoing viability. There was a focus on the potential impacts on profit, reputation and credit rating.
The desire to implement a scenario framework such as this came from the combination of a view that senior management needed to play a more active role in risk management as well as supporting compliance with overriding regulatory requirements.
There has recently been a rise in guidance set out by various regulatory bodies calling for increasingly robust risk management and use of quantitative methods such as scenario analysis, stress testing and reverse stress testing, for example the latest version of the UK Corporate Governance Code published by the Financial Reporting Council. Although this was not the only driver for our client seeking to implement a robust framework and model for ongoing risk management, it proved a significant impetus.
"There has recently been a rise in guidance set out by various regulatory bodies calling for increasingly robust risk management and use of quantitative methods such as scenario analysis, stress testing and reverse stress testing."
We were asked to aid the implementation of a dedicated risk management framework. Our role initially was to advise and inform specific stresses and scenarios to be analysed, covering a range of diverse risk categories from financial, operational and strategic risks. We worked closely with our client’s in-house risk management team to identify and define potential stresses and scenarios as part of evaluating the overall exposure to risk factors.
In the first instance, we first considered the risk management team’s catalogue of existing risks, meeting with risk owners and various corporate departments to ensure that the catalogue was up-to-date and incorporating new scenarios as necessary. Where we identified gaps in the catalogue, experts were consulted to ensure that all key risk factors were addressed.
We then helped to advise on the implementation of our client’s bespoke model to analyse and understand the stresses and scenarios, as well as identifying ‘breaking points’ that threatened viability – a process known as reverse stress testing. This analysis was used by senior management to allow them to take appropriate action in response to identified risk factors, re-evaluate risk appetites, alter and change strategic focus, inform business plan decisions and allocate capital across the business.
This is a simple schematic illustration of the model, showing an increasing level of impairment to ongoing viability, corresponding to increasing levels of stress being applied. The model can be used to identify trigger points where risk metrics move close to tolerance ranges, highlighting possible signs of emerging distress prior to a breach, thus enabling senior management to take pre-emptive action to mitigate the stress.
As a direct result of our work the client introduced a governance committee to focus on risk, that reports directly to the board and with responsibility for monitoring known and emerging risks and ensuring that sufficient mitigation and controls are in place.
Ultimately our work was well received by the client, and was used to provide support for their overall company-wide risk management system, as well as enabling better understanding as to how they could be affected by changes in the overall operating environment and identification of vulnerabilities in their business model.
Scenario analysis involves the use of discrete, internally consistent views of how the world will look in the future to assess the effect on an objective of one or more events. It is the process of visualising which future conditions or events are probable, what their consequences or effects would be like, and how to respond to or benefit from them.
Stress testing assesses the impact of events having extreme impact. It differs from scenario analysis in that it focuses on the direct impact of a change in only one event or activity under extreme circumstances, as opposed to focusing on changes on a more normal scale. Stress testing is used as a complement to probabilistic measures to examine the results of low likelihood, high impact events that might not be captured adequately by distributional assumptions used with probabilistic techniques.
Reverse stress testing
Reverse stress testing is similar to standard stress testing, but starts from a presumption of failure and seeks to identify the circumstances in which this could occur. In other words, we ask what outcomes could bring an organisation to the brink of failure, and then ask what could give rise to those outcomes.
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