Reverse stress testing

Institutions should perform adequate reverse stress tests as part of the stress testing programme, sharing the same governance, an effective infrastructure and quality standards, and to complement other types of stress testing, taking into account the nature, size, scale and complexity of their business activities and risks. Small and less complex institutions may focus more on the qualitative aspects of reverse stress testing while more sophisticated reverse stress testing techniques are required of larger or more complex institutions. The reverse stress testing should be clearly defined in terms of responsibilities and resources allocated and should be supported by an infrastructure that is suitable and flexible and by written policies and procedures. Reverse stress testing should be carried out regularly by all types of institutions and at the same level of application as ICAAP and ILAAP (e.g. institution wide and covering all relevant risk types).

Institutions should include scenarios identified through the reverse stress testing to complement the range of stress test scenarios they undertake and, for comparison purposes, in order to assess the overall severity, allowing the identification of severe but still plausible scenarios. Reverse stress testing should be useful for assessing the severity of scenarios for ICAAP and ILAAP stress tests. The severity of reverse stress testing scenarios can also be assessed by comparing it to, inter alia, historical or other supervisory and publicly available scenarios.

In carrying out their reverse stress tests, institutions should also consider whether failure of one or more of their major counterparties or a significant market disruption arising from the failure of a major market participant (in a separate or combined manner) would cause the pre-defined outcome.

Institutions should use reverse stress testing as a regular risk management tool in order to improve their awareness of current and potential vulnerabilities, providing added value to institutions’ risk management. The principle of proportionality applies to all aspects of the use of reverse stress testing. Institutions should also consider that the pre-defined outcome of reverse stress testing can be produced by circumstances other than the circumstance analysed in the stress test.

Institutions should use reverse stress testing in planning and decision-making and to challenge their business models and strategies in order to identify and analyse what could possibly cause their business models to become unviable, such as the assessment of both the ability to generate returns over the following months and the sustainability of the strategy to generate returns over a longer period based on strategic plans and financial forecasts. The engagement of the management body and senior management throughout the process is expected.

Where reverse stress testing reveals that an institution’s risk of business model failure is unacceptably high and inconsistent with its risk appetite, the institution should plan measures to prevent or mitigate such risk, taking into account the time that the institution should have to react to these events and implement those measures. As part of these measures, the institution should consider if changes to its business model are required. These measures derived from reverse stress testing, including any changes to the institution’s business plan, should be documented in detail in the institution’s ICAAP documentation.

Institutions with particular business models, e.g. investment firms, should use reverse stress testing to explore their vulnerabilities to extreme events, in particular where their risks are not sufficiently captured by more traditional (e.g. solvency and liquidity) stress scenarios based on macroeconomic shocks.

Institutions using internal models for credit risk, counterparty credit risk and market risk, when carrying out reverse stress testing in accordance with Articles 177, 290(8) and 368(1)(g) of Regulation (EU) No 575/2013, should endeavour to identify severe, but plausible, scenarios that could result in significant adverse outcomes and potentially challenge an institution’s overall viability. Institutions should see these reverse stress tests as an essential complement to their internal models for calculating capital requirements and as a regular risk management tool for revealing the possible inadequacies of these internal models. In severe stress scenarios, even though this should not necessarily be taken as an indication that the modelling of the inputs into the IRB formula are inadequate, model risk will increase and may lead to a breakdown in the model’s predictability.

Institutions should perform qualitative analyses in developing a well-defined narrative of the reverse stress testing and a clear understanding of its feedback and non-linear effects, taking into account the dynamics of risk, and combinations of and interactions between and across risk types. When developing a well-defined narrative, an institution should consider external exogenous events such as economic events, an industry crash, political events, litigation cases and natural events, as well as risk factors such as operational risks, concentration and correlations, reputational risks and loss of confidence, and combinations of these events and factors. The proper engagement of the management body of the institution in the discussions of the narrative is fundamental, taking into account possible specific vulnerabilities and the impact on the whole institution.

Institutions should perform quantitative and more sophisticated analyses, taking into account the institution’s size as well as the nature, scale, complexity and riskiness of its business activities, in setting out specific loss levels or other negative impacts on its capital, liquidity (e.g. the access to funding, in particular to increases in funding costs) or overall financial position. Institutions should work backwards in a quantitative manner to identify the risk factors, and the required amplitude of changes, that could cause such a loss or negative impact (e.g. defining the appropriate loss level or some other measure of interest on the balance sheet of the financial institution such as capital ratios or funding resources). Institutions should understand and document in detail the drivers of risk (e.g. outputting the exact factor draws that had the most impact on the portfolio tail region), the key business lines and a clear and consistent narrative around weaknesses and the corresponding scenarios (e.g. about the underlying assumptions and sensitivity of the results to those assumptions over time) that cause the pre-defined outcomes and the events chain and the likely flow through (e.g. the most important factors may be mapped to macroeconomic variables according to the combinations for a given target loss/capital in a portfolio), identifying hidden vulnerabilities (e.g. hidden correlations and concentrations) and overlapping effects.

Institutions should, where appropriate, use sensitivity analyses as a starting point for reverse stress testing, e.g. shifting one or more relevant parameters to some extreme to reach pre-defined outcomes. An institution should consider various reverse sensitivity analyses for credit risk (e.g. how many large customers would have to go into default before the loss absorbing capital is lost), market risk, liquidity risk (e.g. stress on deposits in the retail sector and circumstances that would empty the institution’s liquidity reserves) and operational risk, among other risks, and a combination analysis where all risks are covered simultaneously. However, an institution should not primarily use a sensitivity analysis and simple metrics to identify the scenario relevant for the reverse stress test. The qualitative analysis should lead to the identification of the relevant scenario, combining expert judgement from different business areas, as thinking might be the most effective way to prevent a business model failure. A joint stressing of all relevant risk parameters using statistical aspects (e.g. volatility of risk factors consistent with historical observations supplemented with hypothetical but plausible assumptions) should be developed. The plausibility of the parameter shifts required to reach the pre-defined outcome gives a first idea about possible vulnerabilities in the institution. To assess the plausibility, historical (multivariate) probability distributions – adjusted, where deemed necessary, according to expert judgements – should, inter alia, be applied. Qualitative analyses and assessments, combining expert judgements from different business areas, should guide the identification of relevant scenarios.

Institutions should use reverse stress testing as a tool to gather insights into scenarios that involve combinations of solvency and liquidity stresses, where traditional modelling may fail to capture complex aspects from real situations. Institutions should use reverse stress testing to challenge their capital plans and liquidity plans. Where appropriate, institutions should identify and analyse situations that could aggravate a liquidity stress event and transform it into a solvency stress event, and vice versa, and eventually to a business failure. Institutions should endeavour to apply reverse stress testing in an integrated manner for risks to capital or liquidity with a view to improving the understanding and the management of related risks in extreme situations.

Institutions should develop scenarios of severe macroeconomic and financial distress, varying in their severity (including system-wide events, legal entity-specific stress and group-wide stress), to be used in recovery plans under Article 5(6) of the Bank Recovery and Resolution Directive (BRRD) and EBA/GL/2014/06, and use specific reverse stress testing to develop ‘near-default’ scenarios (institution close to failure but no further) and as an input to inform and test the efficiency and effectiveness of their recovery actions and their recovery planning, and analyse sensitivities around corresponding assumptions. Such ‘near-default’ scenarios should identify and describe the point that would lead an institution’s or a group’s business model to become non-viable unless the recovery actions were successfully implemented. The scenarios should allow the estimation of results and the suitability of all the available recovery options. The terminology used in the description of recovery scenarios should help to determine which recovery options were tested under particular stress scenarios. The description should have a sufficient level of detail, through both a set of quantitative assumptions and a qualitative narrative, in order to determine whether or not the scenario is relevant for the institution and how severe it is. The events should be described in a logical sequence and the assumptions underlying the main drivers (e.g. net income, risk-weighted assets (RWAs), capital) should be laid down very clearly. The scenarios should also take into account a possible estimation of the cross-effects of executing different recovery plan options in the same stress scenario. The scenarios should also allow an understanding of how the events unfold by providing an appropriate timeline that makes it clear at which point in time certain actions will be developed (with implications for their credibility and feasibility). The purpose of this exercise is to test the effectiveness of the institution’s recovery options in restoring financial strength and viability when the institution comes under such severe stress.

Because of the different objectives of the two sets of reverse stress tests, the stress tests for ICAAP and ILAAP purposes and recovery planning should not be interlinked but compared with one another.

Institutions should use reverse stress testing to assist with the development, assessment and calibration of the ‘near-default’ scenarios used for recovery planning.

Institutions should use reverse stress testing to identify the risk factors and further understand and describe the scenarios that would result in ‘near default’, assessing effective recovery actions that can be credibly implemented, either in advance or as the risk factors or scenarios develop.

Reverse stress testing should contribute to the recovery plan scenarios by using a dynamic and quantitative scenario narrative, which should cover: