The Risks Interconnections Map shows how all risks are connected to others and underlines the importance of dealing with risk in an holistic manner. The map visualises the strength of connection between individual risks – the most strongly connected risks could merit additional attention due to the multiple ways they affect or are affected by other risks.
Reverse stress testing consists in identifying a significant negative outcome and then identifying the causes and consequences that could lead to such an outcome. In particular, a scenario or combination of scenarios that threaten the viability of the institution’s business model is of particular use as a risk management tool in identifying possible combinations of events and risk concentrations within an institution that might not be generally considered in regular stress testing.
SYSC20 introduced rules on reverse stress testing, which require a firm to identify and assess events and circumstances that would cause its business model to become unviable. This chapter also requires the firm’s senior management or governing body to review and approve the results of the reverse stress testing exercise. This should help the firm’s senior management to identify the firm’s vulnerabilities and design a strategy to prevent or mitigate the risk of business failure.
The reverse stress testing requirements are an integral component of a firm’s business planning and risk management under SYSC.
In policy statement 09/20, “Stress and Scenario Testing Feedback on CP08/24 and final rules”, the Financial Services Authority introduced reverse stress-testing requirements for firms to identify and assess scenarios most likely to cause their current business models to become unviable.
The benefits of reverse stress testing are:
- 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.
The key messages for firms are summarised as follows:
- Board and senior management should actively engage in stress and scenario testing, taking ownership and responsibility for establishing an effective stress testing programme and infrastructure in the firm.
- Senior management should take a key role in implementing the firm’s stress testing programme by being actively involved throughout the process, including in scenario selection.
- Senior management should take action as a result of stress testing and integrate stress testing outputs into the firm’s decision-making process.
- Firms should establish a stress testing programme covering all relevant levels of its business, all risk types and over a range of severities.
- Stress and scenario testing should be undertaken on a forward-looking basis, with sufficient use of firm-wide stress testing helping firms to identify risk concentrations, assess interdependencies and understand second-order effects.
- Firms should establish a robust stress testing infrastructure with appropriate IT systems and resources in place. The infrastructure should be periodically reviewed by senior management for its continued effectiveness.
- Firms should have clearly documented policies and procedures to enable effective implementation and maintenance of the stress testing programme, which should be periodically reviewed by senior management.
As long as human behavior is coupled with free enterprise, it is unrealistic to expect that market crashes, manias, panics, collapses, and fraud will ever be completely eliminated from our capital markets. The best hope for avoiding some of the most disruptive consequences of such crises is to develop methods for measuring, monitoring, and anticipating them. By using a broad array of tools for gauging systemic exposures, we stand a better chance of identifying “black swans” when they are still cygnets.
Measuring Systemic Risk in the Finance and Insurance Sectors
Monica Billio, Mila Getmansky, Andrew W. Lo, and Loriana Pelizzon