Stress tests should be geared towards the events capable of generating most damage whether through size of loss or through loss of reputation. A stress testing programme should determine what scenarios could challenge the viability of the bank (reverse stress tests) and thereby uncover hidden risks and interactions among risks.
Commensurate with the principle of proportionality, stress tests should be geared towards the most material business areas and towards events that might be particularly damaging for the firm. This could include not only events that inflict large losses but which subsequently cause damage to the bank’s reputation.
Reverse stress tests start from a known stress test outcome (such as breaching regulatory capital ratios, illiquidity or insolvency) and then asking what events could lead to such an outcome for the bank. As part of the overall stress testing programme, it is important to include some extreme scenarios which would cause the firm to be insolvent (ie stress events which threaten the viability of the whole firm).
For a large complex firm, this is a challenging exercise requiring involvement of senior management and all material risk areas across the firm.
A reverse stress test induces firms to consider scenarios beyond normal business settings and leads to events with contagion and systemic implications. For example, a bank with a large exposure to complex structured credit products could have asked what kind of scenario would have led to widespread losses such as those observed in the financial crisis.
Given this scenario, the bank would have then analysed its hedging strategy and assessed whether this strategy would be robust in the stressed market environment characterised by a lack of market liquidity and increased counterparty credit risk.
Given the appropriate judgments, this type of stress test can reveal hidden vulnerabilities and inconsistencies in hedging strategies or other behavioural reactions.
Before the financial market turmoil, such an analysis was considered of little value by most senior management since the event had only a remote chance of happening. However, banks now express the need for examining tail events and assessing the actions to deal with them.
Some banks have expressed successes in using this kind of stress test to identify risk concentrations and vulnerabilities.
A good reverse stress test also includes enough diagnostic support to investigate the reasons for potential failure.
Areas which benefit in particular from the use of reverse stress testing are business lines where traditional risk management models indicate an exceptionally good risk / return tradeoff; new products and new markets which have not experienced severe strains; and exposures where there are no liquid two-way markets.