Financial Services Authority reports on thematic review of stress testing
The FSA notes that stress testing and scenario analysis are essential tools for financial firms' planning and risk management processes. By using stress testing and scenario analysis, ‘senior management can assess and adjust their view of the risks that face their firm, plan mitigating action and identify risk concentrations’. The wider use of stress testing by major firms has the potential to reduce risks to the UK financial system, says the FSA. The key conclusions from the study are as follows (verbatim): • Close engagement by senior management resulted in the most effective stress testing practices. There was a range of practice in the extent of senior management engagement. Good practice was most in evidence in firms where senior management took a direct interest in their firm's stress testing programme, resulting in scenario selection and management reporting that addressed the concerns of management. In some firms, chief executives were involved personally at the review and challenge stages. In other firms, a high-ranking officer, such as a chief risk officer, took personal charge of the stress testing programme, ensuring that it functioned effectively within their organisation, and briefing senior management. A few firms did both. • Good practice was observed where firms conducted firm-wide stress tests of scenarios which were plausible, yet under which profitability was seriously challenged, key business planning assumptions were flexed or scope for mitigating action was constrained. We were struck by how mild the firm-wide stress events were at some of the firms we visited. On the evidence of our review, few firms were seeking out scenarios such as those that might require a dividend cut, generate an annual loss, or result in shortfalls against capital requirements while still remaining plausible. The current high level of profitability and capitalisation in many firms may provide part of the explanation. But additional reasons could be that firms might underestimate the likelihood of severe events or, where mitigating action is envisaged, they might overestimate their ability to take action that is both effective and timely. As a result, senior management may not be presented with scenarios that force consideration of more challenging issues. • Communicating results clearly and accessibly was important for many firms. Good practice that we observed included presentation of stress testing or scenario analysis results to senior management that: (a) showed the effects of the stress test over a multi-year time horizon; (b) showed the effects of the stress test across a selection of metrics (for example, its effect on capital, the balance sheet, or P&L); and (c) separately presented the effects of possible management action on these same metrics in the stress scenarios. • Good practice entailed using group-wide stress testing and scenario analysis to challenge business planning assumptions. A small number of firms chose not to operate a group-wide programme of stress testing. Apart from questions of compliance with proposed Handbook requirements, it seemed to us that senior management might not assess the risks facing their firm as effectively as others in our sample by failing to seek evidence that might confirm or challenge their own opinions about those risks. Read the full study report at: http://www.fsa.gov.uk/pubs/ceo/stress_testing.pdf
•Date: 19th October 2006• Region: UK •Type: Article •Topic: Operational risks |
