Policy Statement 09/20. Financial Services Authority. Stress and Scenario Testing. Feedback on CP08/24 and final rules

Transcription

1 Policy Statement 09/20 Financial Services Authority Stress and Scenario Testing Feedback on CP08/24 and final rules December 2009

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3 Contents 1 Overview 3 2 Consultation feedback and analysis of responses 7 3 Reverse stress-testing 41 4 Other points 44 Annex 1: Annex 2: Annex 3: Annex 4: Annex 5: Annex 6: Annex 7: List of non-confidential respondents to CP08/24 Cost-benefit analysis Good practice in stress and scenario testing Additional guidance to insurers on the Pillar 2 capital planning stress test List of regulatory documents relating to stress testing Our approach to stress testing List of acronyms Appendix 1: Handbook text The Financial Services Authority 2009

4 This Policy Statement reports on the main points arising from responses to Consultation Paper 08/24 Stress and scenario testing Feedback on CP08/24 and final rules and publishes final rules. Please address any enquiries to: Piers Haben Pillar 2 & Stress Testing Policy Financial Services Authority 25 The North Colonnade Canary Wharf London E14 5HS Telephone: Fax: [email protected] Copies of this Policy Statement are available to download from our website Alternatively, paper copies can be obtained by calling the FSA order line:

5 1 Overview 1.1 The FSA s integrated approach to stress testing 1 consists of three main elements: Firms own stress testing. We expect firms to develop, implement and action a robust and effective stress testing programme which assesses their ability to meet capital and liquidity requirements in stressed conditions, as a key component of effective risk management. FSA stress testing of specific firms. The FSA runs its own stress tests on a periodic basis for a number of firms. We do this regularly for specific high impact firms and for other firms as the need arises, to assess their ability to meet minimum specified capital levels 2 throughout a stress period. Simultaneous system-wide stress testing undertaken by firms using a common scenario for financial stability purposes. 1.2 The diagram below illustrates the FSA s integrated stress testing framework including the three elements described above. Interlinked analysis Micro-prudential analysis Macro-prudential analysis Setting stress testing policy Firms own stress testing Capital Supervisory stress testing FSA stress testing of specific firms System-wide stress testing Simultaneous stress testing Setting scenarios Monitoring and aggregation Liquidity Reverse stresstesting Assessment against minimum specified capital and liquidity requirements Financial stability purposes FSA Objectives 1 Details on the FSA s integrated approach to stress testing can be found in Annex 6. 2 For banks this includes all relevant capital ratios in the in the supervisory framework including individual capital guidance (ICG) and other relevant ratios: Financial Services Authority 3

6 1.3 These three elements are interlinked and mutually reinforcing. This Policy Statement (PS) focuses primarily on improvements we expect to see in firms own stress testing the first element identified above. In December 2008, we published Consultation Paper 08/24 (CP08/24): Stress and scenario testing 3 which sets out specific measures to strengthen firms approaches to stress testing. In addition to outlining general areas for improvement in stress testing, we formally consulted on introducing a reverse stress-testing requirement. We also consulted on clarifications of our rules and guidance in several policy areas including Pillar 2 capital stress and scenario testing (our ICAAP 4 rules) and where, for BIPRU firms, internal models are used to assess Pillar 1 capital requirements. The importance of stress testing was also outlined in DP09/2, published in March 2009 simultaneously with The Turner Review, emphasising that we regard stress testing as a critical part of our regulatory architecture. 1.4 This PS sets out a summary of the responses received against each question raised in CP08/24, describes our final policy and includes the Handbook text that will give effect to that policy. We have provided additional comments where appropriate to explain our requirements. In particular we comment on the following aspects in some detail: Stress testing infrastructure: We remind firms about the importance that they establish, implement and action an effective stress testing programme. We have included an annex (Annex 3) outlining good practice in this Policy Statement. Pillar 2 stress testing: We describe our expectations for the appropriate severity of Pillar 2 stress scenarios. We outline the role of supervisory recommended scenarios in helping firms to calibrate their own scenarios and clarify our approach to assessing the credibility of management actions in a stress scenario. Reverse stress-testing: We introduce reverse stress-testing requirements for firms to identify and assess scenarios most likely to cause their current business models to become unviable. We address concerns about proportionality in relation to these requirements by describing the range of approaches that firms might take. In addition, our final policy adjusts the scope of application of the requirements for investment firms, compared with the consultation proposal. Specific concerns from insurers: We have addressed in Annex 4 a range of issues relating to insurers stress testing, to assist their understanding of our requirements, and in particular, the capital planning stress test. 1.5 Accompanying this Policy Statement is a short Consultation Paper that clarifies our approach to capital planning buffers, which are set for BIPRU firms as part of Pillar 2 capital planning, in order to help firms understand better how this buffer may be drawn down during adverse external circumstances Internal capital adequacy assessment process rules are set out in our General Prudential Sourcebook (GENPRU) under which a firm is required to self-assess adequate financial resources to cover its particular individual risks. 4 PS09/20: Stress and scenario testing (December 2009)

7 Who should read this paper? 1.6 This paper should be of interest to banks, building societies, insurers, CRD investment firms and smaller investment firms. Members of board risk committees (in particular those who are non-executive directors), senior management and chief risk officers, as individuals responsible for implementing and overseeing an effective stress testing programme within a firm, should read this paper to understand our expectations of firms in relation to stress testing. A wide range of other staff in these firms should also read this paper. Responses and our final policy approach 1.7 The consultation period for CP08/24 closed on 31 March We received 28 responses from a range of firms, trade associations and individuals. We are grateful to all the respondents for taking time to send us their views. A list of all non-confidential respondents can be found in Annex Section 3 of this document sets out a timetable for implementation of the new reverse stress-testing requirement. Firms identified as being subject to the reverse stress-testing requirement will have 12 months from publication of this Policy Statement (14 December 2010) before the requirements become effective. Structure of the Policy Statement 1.9 The rest of the PS is set out as follows: Section 2 summarises feedback received and our responses; Section 3 contains details of the new reverse stress-testing requirements; Section 4 covers other points relating to stress testing; Annex 1 lists all non-confidential respondents to the consultation; Annex 2 includes detail on our revisited CBA on the new reverse stress-testing requirements; Annex 3 summarises our view of good practice points in relation to building a robust stress testing infrastructure; Annex 4 relates to specific guidance to insurers on the Pillar 2 the capital planning stress test; Annex 5 includes a list of regulatory documents relating to stress testing; Annex 6 provides a high-level overview of the components of our stress testing framework; Annex 7 contains a list of acronyms used throughout this document; and Appendix 1 contains the final Handbook text. Financial Services Authority 5

8 CONSUMERS This paper is important for consumers because our prudential requirements and high-level standards (SYSC) for BIPRU firms and insurers are a way of achieving our consumer protection objective. Changes to these requirements therefore have potential impact on consumers. Firms are required to undertake stress and scenario testing for risk management purposes, to assess the adequacy of financial resources and contingency plans against potential adverse circumstances. 6 PS09/20: Stress and scenario testing (December 2009)

9 Consultation feedback and 2 analysis of responses 2.1 This section outlines the responses received to the questions posed in CP08/24, our views on those responses and our policy decisions on how to proceed. 2.2 Firms broadly welcomed the proposals to introduce a reverse stress-testing requirement and recognised the benefits of stress testing both for firms senior management and for the regulator. Respondents support for our proposals was on the basis that reverse stress-testing requirements would be applied in an appropriate and proportionate way, which we fully intend to do. The main focus of concern was the scope of the reverse stress-testing requirement for investment firms. There was also concern about the additional costs firms could face in implementing the new requirement. We have addressed these and other issues in our analysis of responses and have narrowed the scope of the reverse stress-testing requirement for BIPRU investment firms to exclude more firms. The deferred implementation date for the new reverse stress-testing requirement for all firms is December 2010 (12 months after publication of this PS). This will ease the implementation task for firms. 2.3 Overall, there was strong support for the clarifications to our rules and guidance on stress testing that we proposed in CP08/24 and we have adopted the consultation proposal with a few minor changes. However, we acknowledge that in some areas, including pension obligation risk, firms would welcome further clarity on our expectations and approach. Work in these areas continues and our further thinking will be communicated to firms in Although generally supportive of the clarifications we proposed, respondents also requested additional guidance from us on elements of Pillar 2 stress testing including the appropriate severity of scenarios used for the capital planning stress. With specific reference to appropriate severity, we have adapted the proposed Handbook language to give firms a fuller explanation of our expectations, which require them to take a more forward-looking and less historical approach to identifying severe scenarios. Financial Services Authority 7

10 Market failure analysis 2.4 CP08/24 proposed changes to the current Handbook rules and guidance on stress and scenario testing. A market failure analysis was provided identifying the key role that stress testing should play in the prudential risk management of a firm. Where stress testing failed to consider the extent and the dynamic effects of changes in the external environment, the result was: the failure of some firms who pursued business plans that became unsustainable as wider market and economic conditions changed; and the need for a number of financial firms to raise additional capital at a time of low market confidence and the difficulties and increased costs that some experienced (leading in some cases to government intervention to provide additional capital). 2.5 We asked: Q1: What is your view of our analysis of the market failures? 2.6 Respondents agreed with our analysis that improved stress and scenario testing arrangements at firms would help to reduce the probability of firms failing, and the consequent impact and wider costs of any financial failure. They understood the need for more regulatory requirements in this area, particularly given the widespread public and political concern arising from the recent market turbulence. 2.7 However, respondents stated that, while our general analysis of market failures in the banking sector was appropriate, stress testing was only one weakness that contributed to those failures. More fundamentally, they considered that inadequate risk management, especially credit risk management and a short-term outlook influenced by inappropriate remuneration structures were the major causes of current problems. 2.8 Some respondents commented that the market failures identified in CP08/24 appeared to be focused on the banking sector, particularly when referring to the failure of firms that pursued business plans that became unsustainable as market and economic changes took place, and the need for some firms to raise additional capital. They suggested that a more detailed market failure analysis should be undertaken in order to fully justify the proposals as they would apply to the insurance sector. 2.9 Respondents also noted that firms have been carrying out stress testing for many years (although not a reverse stress-test of the type proposed) and that this is already an integral part of the ICAAP/ICAS process for many firms One respondent suggested that our commentary appeared to be directed at proprietary organisations rather than mutual organisations. Two respondents suggested that some smaller organisations are less complex and more conservative in their risk appetite and proposed that a minimum size be identified below which stress testing would not be required. 8 PS09/20: Stress and scenario testing (December 2009)

11 Our response: Developing our stress testing policy is one aspect of our regulatory response to the financial crisis that began in While the impact of poor stress testing has been most observable in banks, insurers have also found themselves under pressure from recent market and economic conditions. The feedback provided to insurers in the Insurance Sector Briefing: Risk & Capital Management Update (September 2008) was referred to in CP08/24. So we maintain that improvements in stress and scenario testing are needed across a range of financial institutions to help ensure that our consumer protection and market confidence objectives are met. Respondents support strengthening stress and scenario testing by building on and improving established practices. At the same time, it is important that application of the approach should be proportionate. This means that our requirements should reflect the nature, scale and complexity of the firms we regulate and the risks that they run. The specific requirements need to recognise relevant differences: in the nature of the businesses of banks, building societies, insurers and investment firms and the risks that they bear; between proprietary and mutual firms; between firms doing new business and those in run-off (for example, stress testing for run-off insurers is likely to be relevant mainly in the context of any restructuring of the firm, or as part of capital planning); between firms with simple risks and those with complex risks; and between risk appetites of firms. However, as the size of the firm is not necessarily an indication of a firm s complexity or the risks that they bear, we do not propose to introduce a minimum limit to our stress testing requirements for banks or insurers. We have decided on some more specific limits in relation to reverse stress-testing, which have narrowed the scope of its application. These are outlined in our response to question five. Cost-benefit analysis (CBA) 2.11 CP08/24 included a CBA of both the introduction of the reverse stress-test and of the proposals clarifying our existing Pillar 1 for BIPRU firms and Pillar 2 stress testing policy for BIPRU firms and insurers The CBA in CP08/24 was conducted under the assumption that the scope of the reverse stress-test would extend to all banks, building societies and insurers and all BIPRU investment firms excluding BIPRU 50k firms with less than 1bn of funds under management We asked: Q2: What is your view of our cost-benefit analysis? Financial Services Authority 9

12 2.14 Although respondents broadly recognised the need for robust stress and scenario testing, many considered that the additional requirements and increased supervisory focus would result in additional costs for firms, and suggested that our cost estimates were understated Respondents were also concerned that, in addition to the initial costs of setting up the reverse stress-tests, there would also be high annual costs in performing the tests and danger of multiple reworking, as had been experienced with the current ICAS/ICAAP processes, which could lead to much higher continuing costs Some insurance firms in particular considered, despite the result of our pre-consultation survey, that the cost of reverse stress-testing would be greater than estimated. Several respondents cited costs of additional actuarial resource as the reason for this. The need for external consultants in this field and the complexity of stress testing at the group rather than solo level could, they suggested, also give rise to additional costs for insurance groups Insurers also expressed concerns about introducing the requirement in 2009, as they focus on the development of models ahead of the implementation of Solvency 2. They questioned whether the benefits of the proposals for insurers would outweigh the costs and suggested that a more robust and detailed analysis of the benefits be undertaken One respondent was concerned that the costs were understated for smaller friendly societies, noting that the average cost for small and medium-sized firms would be the same, so that the burden would appear to be proportionately greater for the smaller organisations. They suggested that a key aspect for the smaller friendly societies would be that reverse stress-testing would need to be largely outsourced to skilled staff. Policyholders of friendly societies, which are member owned, would be directly impacted by the costs and benefits. Our response: We acknowledge the concerns regarding the initial and continuing costs arising from implementation of the reverse stress-testing requirement, particularly given resource pressures on firms from other regulatory requirements. We accept that it will take time for firms to develop the skills and processes required for reverse stress-testing and that there may be additional costs during the introductory phase. However, the 12-month implementation period of the reverse-stress testing requirement should give firms time to plan their implementation and enable them to raise questions with us to ensure that our requirements are properly understood. Firms should note that in Section 3 of this PS, we have included practical information and further assistance to firms to clarify our requirements and expectations. In particular, reverse stress-testing may initially have a strong qualitative element with a focus on identification of the types of scenarios that could cause a firm s business model to fail and we accept that more quantitative elements of reverse stress-testing may need to be developed over a longer period. Nonetheless, in light of the responses received to the consultation, we have decided to: revise the scope of the reverse stress-test by reducing the number of BIPRU investment firms subject to this requirement and revisit the corresponding compliance cost estimates; and 10 PS09/20: Stress and scenario testing (December 2009)

13 reconfirm our compliance cost estimates with some consultancy firms that review, develop and implement firms reverse stress-testing methodologies. Consequently, we have revised our CBA (see Annex 2). The new analysis concludes that: total compliance costs for investment firms are now lower due to the narrower scope of the reverse stress-testing requirements; our previous estimates were broadly correct and, subject to the relevant caveats, provide a useful indication of the costs arising from reverse stress-testing; and the 12-month implementation period should give firms valuable time to develop, update and implement their models, and recruit and train staff. Reverse stress-testing of a firm s business model vulnerabilities 2.19 The reverse stress-testing requirement proposed in CP08/24 would for the first time require a firm to identify explicitly and assess the scenarios most likely to render its business model unviable A firm s business model was described as being unviable at the point when crystallising risks cause the market to lose confidence in the firm. A consequence of this would be that counterparties and other stakeholders would be unwilling to transact with or provide capital to the firm and, where relevant, that existing counterparties may seek to terminate their contracts. Such a point could be reached well before a firm s regulatory capital is exhausted CP08/24 stated the intention behind this new requirement was to encourage firms to: first, explore more fully the vulnerabilities of their current business plan (including tail risks as well as milder adverse scenarios); second, make decisions that better integrate business and capital planning; and third, improve their contingency planning We asked: Q3: Do you consider our reverse stress-testing proposal reasonable? 2.23 Respondents generally considered that, subject to cost considerations, the reverse stress-testing proposal was a reasonable requirement that could be undertaken in an appropriate and proportionate way and readily adapted to changing conditions. They suggested this would lead to useful additional information for management and improve contingency planning and management of business failure. However, there were some reservations about the practical application of the proposal in CP08/24. These included: the use of the reverse stress-test as a risk management tool; the probability of a reverse stress-test scenario arising in practice and the implications for a firm s capital needs; the interaction of reverse stress-testing with a firm s risk appetite/tolerance; and the level (group or solo) at which the reverse stress-test should be undertaken. Financial Services Authority 11

14 Risk-management tool 2.24 A number of respondents commented on the use of the reverse stress-test as a risk-management tool. Respondents generally saw the risk management benefits of the proposed requirements. The key benefits outlined by respondents included: 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 Some respondents suggested that we should encourage the management bodies of firms to increase their focus on scenario development and analysis. The rationale was that such a requirement would involve management bodies thinking through a range of extreme scenarios, potential mitigants and trigger points for action that would lead them to focus on big issues rather than detailed sets of numbers. The involvement of non-executive directors, to ensure senior management take an appropriately broad view and pay due attention to extreme scenarios, was also advocated There were, however, some concerns that the benefits of reverse stress-testing might not be realised if it were implemented inappropriately, for example if: reverse stress-testing added another layer of complexity to the detailed information already available from firms Pillar 2 modelling and detracted from a longer-term commercial view; the gains expected were from the narrative and thought process of the reverse-stress scenarios, rather than from the numerical analysis that may be required, there would be a danger of firms becoming bogged down in the financial analysis. This would overlook the real benefit from considering appropriate mitigations and process changes; reverse stress-testing normally resulted in a requirement for additional capital. if the FSA, rather than a firm s management, specified the situations likely to lead to the failure of its business model that a firm should use; and if detailed rules on reverse stress-testing diverted insurers resources away from planning to implement Solvency 2 by Clarification was also sought on why the reverse stress-test should apply to insurers already in run-off. Both Pillar 1 and Pillar 2 already require the costs involved in closing the fund and running off the liabilities to be considered, if this provides a higher capital requirement than on a going concern basis. Reverse stress-test scenarios and impact on capital requirements 2.28 A number of respondents queried the sorts of scenarios that firms should consider under reverse stress-tests and expressed concern about the potential links between reverse stress-testing and capital needs. These concerns were highlighted despite CP08/24 stating 12 PS09/20: Stress and scenario testing (December 2009)

15 that the reverse stress-test did not mean we were pursuing a zero-failure approach. Reverse stress-testing was proposed to be added to SYSC, recognising its importance as a risk management requirement, and not as a means of determining capital requirements The key issues raised were whether the scenarios should be plausible and whether the results of the reverse stress-test would be used by supervisors to set individual guidance. In particular, concern was expressed that supervisors might set individual capital or liquidity guidance requiring a firm to have capital or liquidity sufficient to mitigate the impact of the reverse stress-test scenario. Respondents suggested that such an approach would be likely to lead to firms not considering scenarios that imply significant erosion of capital, as this would increase the individual capital guidance set by supervisors, who might view the consequences of the scenario as a risk to our statutory objectives. Respondents therefore sought clarity about how the results of the reverse stress-test would be used in setting individual capital guidance (ICG), when considered alongside ICAAP/ICAS and ARROW In order to avoid such outcomes, respondents suggested that we should state that firms undertaking a reverse stress-test should consider plausible rather than remote scenarios and that the Handbook text should be amended to reflect this. Respondents provided a range of justifications for their thinking, including concerns that firms may find it difficult to consider hypothetical remote scenarios or that remote scenarios may not provide much insight in terms of risk management One respondent commented that not all failure events are driven by lack of capital, as significant operational risks or changes in market perception, for example, could cause a firm to fail. They suggested that the text should be altered to address this. Terminology 2.32 One respondent suggested that the term reverse stress-testing should be included in the Handbook Glossary. Alternative suggestions to our proposed terminology included business model stress test. Risk appetite 2.33 A number of respondents commented on the Handbook text provision requiring a firm to put in place risk mitigation where a reverse stress-test reveals a risk of business failure inconsistent with the firm s risk appetite (SYSC R (2) in the draft Handbook text in CP08/24). The main point raised was that some firms considered business failure, by definition, as being outside their risk appetite One respondent noted that the reverse stress-test could reveal two types of risk that could lead to business failure: first, those risks that are inconsistent with risk appetite and need to be mitigated; and second, risks that are so remote they are consistent with the firm s risk appetite It was suggested that SYSC G in CP08/24 should focus on the less remote risks, requiring firms to develop risk mitigation programmes for the risks of the first type and to state reasons for accepting risks of the second type. Financial Services Authority 13

16 2.36 A further comment was that the proposed rules implied that a firm with a low risk appetite would be required to take action before a firm with a high risk appetite. The respondent considered that regulatory requirements should not depend on a firm s risk appetite. They suggested that reference should be made to a firm taking action when the tests show an unacceptably high level of risk in absolute terms. Level of the reverse stress-test: group versus solo 2.37 Some respondents expressed a preference for the reverse stress-test to be conducted at group level. This was because the costs involved in conducting additional reverse stress-testing at a more granular level (business unit or solo regulated entity level) would be considerably higher and the benefits of doing so are unclear as they would depend upon the firm s organisational and legal structure Conversely, there were concerns from one respondent about the difficulty in practice for global financial firms in identifying scenarios where business plans become unviable given their many different, long-term risk exposures that may have complex correlations. There could be a significant number of scenarios that could cause the current business plan to become unviable and considering management actions for multiple scenarios would be demanding. The respondent suggested that the main benefit from the exercise would result from the thinking behind the scenarios rather than their modelling. There was also concern that undue focus on such scenarios may divert attention away from longer-term commercial strategies and investments In addition, for firms operating internationally, respondents raised potential jurisdictional issues concerning interaction with non-uk parents. Some firms suggested that the highest-level entity in the UK be the focus of the reverse stress-test required by the FSA if the parent company were outside the UK. Respondents preference would be for firms to be able to decide for themselves, on a discretionary basis, how much reverse stress-testing was undertaken at the solo level, business level or group level, with clear Handbook guidance about the minimum standards that apply Some respondents also argued that compliance with the guidance set out in SYSC G (2) in CP08/24 (indicating that we may request firms to quantify the impact on financial resources that would place a firm in situation of business failure) would be unlikely to be possible or meaningful for a subsidiary. Respondents suggested that it is not clear what level of capital resources would constitute business failure, as external counterparties generally look to the level of capitalisation of the group rather than of the individual subsidiary, particularly where the entity benefits from a parental guarantee. Our response: In view of the general support for our proposal, we are introducing requirements for reverse stress-testing as part of the suite of stress testing that firms are required to undertake. At the same time we are clarifying our requirements, to address concerns arising in the consultation. As noted above, we are allowing a period of 12 months before our reverse stress-testing requirements come fully into force. 14 PS09/20: Stress and scenario testing (December 2009)

17 Risk management tool The purpose of the reverse stress-test is to identify and consider scenarios that would lead to a firm s business model becoming unviable. Our view is that this is an important complement to the suite of stress tests that firms are required to carry out. However, we are clear that the primary use of reverse stress-testing is as a risk management tool to improve business planning and risk management rather than to inform decisions on appropriate levels of capital or liquidity specifically. Supervisors are likely to review a firm s reverse stress-tests as part of the ARROW risk assessment and alongside the firm s ICAAP/ICAS, and will regard reverse stress-testing as a complement to these processes. We agree that an important benefit of reverse stress-testing is the thinking behind the scenarios. Our requirement is expected to encourage improved understanding of risks throughout an organisation, especially at senior levels. This should help to ensure that adequate attention is given to scenarios in which a firm s business model would become unviable and that appropriate strategies, risk mitigation and contingency plans are in place. It is not intended to distract the attention of management from making commercial decisions, but rather to help ensure that regulated firms are sufficiently robust in changing conditions. We also consider the term reverse stress-test to be appropriate. Such stress testing starts from an outcome (i.e. failure of the business) and identifies circumstances in which this may occur, rather than testing for outcomes arising from changes in circumstances of different likelihoods. As with other aspects of risk management, reverse stress-testing should be implemented proportionately. So, for example, smaller and less complex organisations would be expected to conduct less complicated reverse stress-testing, possibly more qualitative than quantitative, but larger and more complex organisations will need to conduct more extensive stress testing, which will be both qualitative and quantitative in nature. Reverse stress-testing scenarios and impact on capital requirements As stated in CP08/24 and above, reverse stress-testing should not be interpreted as introducing a zero-failure regime or a means of directly increasing firms capital requirements. It is essential that firms identify the prospective drivers of failure and use this information to ensure that the relevant risks are sufficiently well-understood and appropriately managed to secure consumer protection and market confidence. 5 However, reverse stress-testing may result indirectly in changes to the levels of capital held by firms. For example, if a firm s reverse stress-testing identifies business model vulnerabilities that have not previously been considered, but which the firm expects to survive according to its risk appetite/tolerance, the firm may decide to take mitigating action or hold a different amount of capital. We agree that not all business failure is driven by lack of capital although this is one factor that should be considered. 5 This view is reinforced in A review of corporate governance in UK banks and other financial industry entities (2009) by Sir David Walker which states that Within the context of stress testing, the board risk committee and board should understand the circumstances under which the entity would fail and be satisfied with the level of risk mitigation that is built in. Financial Services Authority 15

18 Risk appetite We note respondents comments about the link between a firm s risk appetite and the risk of business failure. Reverse stress-testing is designed to identify issues, such as risk concentrations, that may affect the alignment of a firm s business strategy and its risk appetite, by requiring the firm to consider scenarios that would cause its business model to fail. In undertaking reverse stress-testing, each firm should consider and document the interaction between business failure and its stated risk appetite. Firms should carefully analyse and review reverse stress-testing outcomes in the context of their risk appetite. This is to ensure that where risk factors are identified in reverse stress-testing that could cause business failure and they are considered sufficiently remote so that they are consistent with the firm s risk appetite, senior management are able to demonstrate this through the outputs of the reverse stress-test. This should enable senior management to justify why no mitigating action is required against these risk factors. Equally, firms may identify risk factors causing business failure that are inconsistent with the firm s risk appetite. That is, the situation may be sufficiently probable that the firm will expect to survive this event. In such cases, we would expect firms to take mitigating action to ensure that its risk appetite is consistent with reverse stress-testing outcomes. Level of the reverse stress-test: group versus solo We have concluded that, for a firm that is a member of a group (including insurance groups that are required to maintain group capital), a UK consolidation group or a non-eea sub-group, the reverse stress-test must be carried out on a solo basis for the firm as well as on a consolidated basis for the group. 6 As we stated in CP08/24, scenarios that constitute business failure for a firm may differ from those that may constitute failure for a group of which it is a member. Whereas the failure of a group is quite likely to be accompanied by the failure of a member firm, the converse may not necessarily be true. Different groups may also differ in the extent to which they are prepared to support a member if the member experiences financial difficulty. Therefore, a combination of top-down and bottom-up approaches is appropriate. This, we believe, will lead to a more complete understanding of the events and circumstances that would break a firm s business. However, consistent with our principal of proportionality for applying the reverse stress-testing requirements, where solo entities are immaterial in a group structure, and their going concern status can be shown to depend primarily on the solvency of the group, the solo reverse stress-test is likely to simply be a function of the group reverse stress-test. In such circumstances, a simple qualitative submission from the solo entity pointing to the group stress test, would suffice. Conversely, an effective group stress test should include risks emanating from all material solo entities whether domiciled in the UK or abroad. 6 This is consistent with statements made in relation to supervision of groups set out in DP09/2 A regulatory response to the global banking crisis which accompanied The Turner Review (March 2009). 16 PS09/20: Stress and scenario testing (December 2009)

19 2.41 We asked: Q4: To what extent are firms already undertaking reverse stress-tests? What is the involvement of senior management in the design and review of these tests? What further steps would firms need to undertake to carry out a reverse stress-test as outlined in these proposals? 2.42 Respondents feedback suggests most firms do not currently undertake reverse stress-testing in the form proposed. Banks 2.43 A small number of banks (according to the British Bankers Association) undertake reverse stress-tests, although it is not clear if their practice is in line with our proposals One respondent did not support a requirement that the test be signed-off by the firm s board, arguing that this would involve the board in operational management of the bank, which is not in line with typical governance structures. It was suggested that stress testing processes and scenarios should be reviewed by appropriate executives appointed by senior management, with scenario approval by a committee which is delegated authority by the Board. Insurers 2.45 Most insurers undertake a variety of stresses through the ICAS process that are overseen by senior management. That process sets no specific reverse stress-test requirement but a few insurance firms have undertaken some work to introduce similar requirements in their business to strengthen their stress testing framework. One respondent, however, suggested that reverse stress-testing may have little additional benefit in the short term due to the variety of stress tests already undertaken One respondent considered that it will take several years for the industry to build reverse stress-tests that are fully integrated and advised that we should be careful to ensure that sufficient time is allowed for these to evolve and remain proportionate in their application and supervision. Early analysis would necessarily be an iterative process given the subjectivity and sensitivities involved Respondents also emphasised the need for significant review of all existing risks by senior management in order to perform reverse stress-tests and suggested that firms may require third party consulting support to do this. Investment firms 2.48 Investment firms do not uniformly carry out reverse stress-tests as stated in CP08/24. However, we note that many have a good understanding of their business models and are experienced in managing key risks during difficult economic conditions. Investment firms also tend to undertake an analysis of orderly wind down, which identifies the issues and costs involved when a business model fails. Financial Services Authority 17

20 Our response: We welcome early moves by firms to develop and incorporate reverse stress-tests as proposed in CP08/24. Having the test signed-off by the firm s board is essential to ensuring senior management engagement. We accept that firms will implement various governance structures, but the framework should ensure thorough challenges and regular review processes by senior management and others, so that reverse stress-testing is meaningful for the organisation. We acknowledge that the reverse stress-test may be a new concept for many firms. With this in mind, the proposed timetable for reverse stress-testing is full implementation 12 months after publication of this PS. Before this, we will ask firms to put together an implementation plan that details the steps they will take to meet the implementation deadline. We will ask firms to send their completed plan to us for review by June Please see Section 3 for more information on the implementation of the reverse stress-test. Insurers We recognise that insurers already undertake a wide range of stress tests and are encouraged that firms have strengthened their stress and scenario testing further and have plans to introduce reverse stress-testing. Proportionality in reverse stress-testing We note the comments received in response to question two about the potential cost of undertaking reverse stress-testing. We are also aware that a wide range of firms will be required to undertake reverse stress-testing. We understand that it will take some time for the process to develop and this will be reflected in our supervisory approach. We will be correspondingly proportionate in assessment of firms reverse stress-testing. We will focus on the outcomes in terms of identifying factors that could lead a firm s business model to fail and how this interacts with a firm s strategy and risk appetite/tolerance. For smaller, simpler firms, reverse stress-testing may primarily be an exercise in senior management judgement focused on scenario selection. For very small firms the submission may be a short written explanation of these factors, which would simply need to be periodically refreshed. It does not necessarily involve detailed modelling. For larger, more complex firms, a more structured and comprehensive approach to reverse stress-testing is expected, in line with our general requirements for firms stress testing infrastructure as outlined in Annex 3. However, even for larger firms we will take a staged approach to our assessment of reverse stress-testing. That is, as reverse stress-testing is introduced, it may at first have a strong qualitative bias with a focus on identification of the types of scenarios that could cause a firm s business model to fail. We accept that more quantitative elements of reverse stress-testing may have to be introduced over a longer time period. Such phasing will be subject to discussion between firms and their supervisors, with reverse stress-testing being meaningful from the outset. 18 PS09/20: Stress and scenario testing (December 2009)

21 2.49 We asked: Q5: Is it appropriate to exclude BIPRU 50K investment firms from the reverse stress-testing requirements if wind-down scenarios are an important part of their risk analysis? Given that our expectations would be based on a proportionate approach by smaller firms, would reverse stress-testing be resource intensive for BIPRU 50K investment firms? 2.50 In general, there was no real objection from banks, building societies or insurers on the topic of the scope of the reverse stress-test. BIPRU investment firms 2.51 However, investment firms did express concerns on scope specifically that the exclusion from reverse stress-testing did not extend to all limited licence firms. Respondents felt that this was not a proportionate approach and that the threshold criteria to determine which investment firms would be in scope were too arbitrary Some firms wanted the proposed exclusions to apply to all limited licence firms, including BIPRU 125K firms, as they argued that conduct of business requirements would be a more appropriate risk mitigant than capital. Our response: We note investment firms concerns about the scope of the reverse stresstesting requirement and the need for us to take a proportionate approach. We also believe that our proposals should take account of our existing requirements to avoid duplication of effort. In particular, some investment firms are required to undertake an analysis of orderly wind down which other BIPRU and INSPRU firms are not required to do. Therefore, we have reviewed the proposals set out in CP08/24 and amended the scope of the reverse stress-testing requirement as it applies to BIPRU investment firms. BIPRU investment firms will be excluded from the reverse stress-testing requirement if they have: where they carry out the regulated activity of managing investments or safeguarding and administrating investments, assets under management or administration 7 of no more than 10bn (or the equivalent amount in foreign currency); total annual fee and commission income arising from its regulated activities of no more than 250m (or the equivalent amount in foreign currency); or assets and liabilities of no more than 2bn (or the equivalent amount in foreign currency). We accept this is itself a relatively arbitrary cut-off measure but we believe it is set at a sufficiently high level to capture the larger, more complex firms. 7 Please note that this explicit reference to assets under administration is included to clarify what we implicitly meant when talking of assets under management in CP08/24. Financial Services Authority 19

22 In order to determine whether a BIPRU investment firm is excluded from the reverse stress-testing requirement, the exclusion criteria (above) will apply on a consolidated basis to all of the BIPRU investment firms within the same UK consolidation group or non-eea sub-group as if they were one firm. We will write to those investment firms which, under the new criteria, we consider to be in-scope of our reverse stress-testing requirements. We will do this in the first quarter of As an additional safeguard measure, if an investment firm satisfies one of the above criteria in any given year, it will be required to comply with the reverse stress-testing requirement for that year and the following two years, whether or not it continues to meet the criteria. In addition, supervisors may ask certain excluded firms to undertake a reverse stress-test if they believe that it would be valuable for the firm to do so. Our revised approach will result in more firms being out of scope than under our previous proposals and we believe that this represents an objective and proportionate approach. This segmentation, however, will be kept under review and we would recommend that the senior management of out-of-scope firms consider the use of reverse stress-testing in managing the risks of their business. Clarification of Pillar 1 stress testing policy 2.53 We asked: BIPRU firms Q6: Do you agree with our proposed clarification of the use of stress testing in IRB quantification? 2.54 We sought to clarify that the purpose of the stress testing IRB requirements in BIPRU , which were copied out from language in the CRD and the Basel text, was to aid calibration and/or validation of IRB estimates; and provided high-level guidance around how this should be carried out Most respondents supported our proposal. However, the response from the main industry associations raised some reservations. These included: an argument that IRB parameterisation and stress testing are two distinct processes that should not be mixed; and stress testing would produce overly conservative estimates that would be inconsistent with the required calibration of the IRB parameters for example, long-run average default rates or the requirement for estimates not to be based purely on judgemental considerations. Our response: We agree with respondents that it would be inappropriate to use highly-stressed inputs where the IRB requirements call for averages, and also that estimates based purely on judgement are not acceptable. However, it is also inadequate to use as IRB estimates simple calculations of past parameters without considering whether this might be an incorrect estimate of what the parameter will be in the future the latter being the target of IRB quantification. So, a properly-specified IRB approach requires a 20 PS09/20: Stress and scenario testing (December 2009)

23 mix of historical data and judgemental adjustment. The inherent difficulty in this process means that accuracy is very challenging to achieve and the language in BIPRU (4.3.88), which is copied out from the CRD, clearly states that a firm must add to its estimates a margin of conservatism that is related to the expected range of estimation errors. Since initial publication of the IRB standards, industry has asked how the IRB stress testing requirement differed from the more general stress testing requirements in Pillar 2 and the specific IRB cyclicality stress test. The potential for stress testing to be used to investigate how parameters might differ from the historical data has been discussed for some time. For example, the Basel Committee s 2005 guidance on loss given default (LGD) estimation highlighted the potential for stress testing calculations to assess the robustness of LGD estimates. We therefore intend to retain the Handbook language proposed in CP08/24 with the exception of a change to the terminology used to describe appropriate severity in the cyclicality stress testing requirement in BIPRU R(2) which is linked with the Pillar 2 stress test. In response to respondents concerns about our use of the term one in 25 years to describe the appropriate severity of stress tests under Pillar 2, we are removing this language from our Handbook text to provide a more comprehensive definition of our expectations in this respect. Consistent with this we have amended the language in the cyclicality stress testing requirement in BIPRU R(2). Credit risk mitigation 2.56 We asked: Q7: Do you agree with our proposed clarification of the use of stress testing for credit risk mitigation purposes? 2.57 Most respondents supported our clarification of the use of stress testing for credit risk mitigation purposes. However, respondents also considered that stress testing for credit risk mitigation should only be applied if the risk is material and not already covered by other assessments. It was noted, for example, that GENPRU already requires stress testing of residual risk. It was also pointed out that some mitigants could fail in stressed circumstances. Our response: The aim of the proposed clarifications was to make clear that all risks associated with credit risk mitigation should be considered in stressed circumstances, including in relation to the value of the mitigation. We considered this to be insufficiently clear in the Handbook text proposed in CP08/24. Our response to questions raised about materiality is that we expect firms to be able to demonstrate to us, at an appropriate level of detail, why they consider a particular risk is not material and need not be stressed. We agree with respondents that some mitigants may fail in whole or part under stressed circumstances and it is vital that firms should identify these scenarios and respond accordingly. Financial Services Authority 21

24 Operational risk 2.58 We asked: Q8: Do you agree with our perception of the role of stress testing in operational risk and our proposal not to prescribe any additional stress testing requirements specifically for operational risk? 2.59 All respondents agreed with our current level of stress testing requirements for operational risk and considered that there was no need to extend them. There was also a general understanding that assessment and management of operational risk should be proportionate to the nature, scale and complexity of each individual firm, so imposing supplementary requirements would not be appropriate for all businesses Some firms suggested that we should offer additional support in identifying boundary events and scenarios to be evaluated to help firms to be better prepared for potential events. Our response: All BIPRU firms are required to have effective processes to identify, manage, monitor and report the operational risks to which they may be exposed. We expect these to be proportionate to the nature, scale and complexity of the firm s activities and the use of scenarios will aid this requirement. We generally expect this practice to be in use among large complex firms. In addition, firms using the Advanced Measurement Approach for operational risk may use scenarios for the quantification of the operational risk capital requirement and/or as a check on the inputs, outputs and accuracy of risk models. We will not prescribe scenarios for operational risk as we consider it more valuable if each firm identifies its own risk profile, as this will improve its understanding of its individual risks and the best way to mitigate them. When we discuss the use of scenario analysis and stress testing of operational risks with firms, we expect a firm in its use of these techniques to have taken full account of the GENPRU and BIPRU requirements and, in particular, to carry out stress and scenario testing that is appropriate given the firm s potential risks. In addition, a firm undertaking stress and scenario testing should determine the impact and frequency of a stress event as well as the controls and mitigants that will be used in the risk management process. All stress and scenario testing processes should be comprehensively documented, which includes recording the scenarios and stresses applied as well as the risk management options, outcomes and actions taken. Handbook changes to clarify Pillar 2 stress testing policy 2.61 Pillar 2 is one of three supervisory Pillars that form the framework for prudential supervision of capital management by banks, credit institutions, investment firms and insurers. Within the overall framework, Pillar 2 specifically requires firms to assess the amount of internal capital they consider adequate to cover risks that they are, or may reasonably expect to be, exposed to. A key element of Pillar 2 is a capital planning 22 PS09/20: Stress and scenario testing (December 2009)

25 stress test to understand how changes in the external environment will affect firms ability to meet their capital needs, including minimum regulatory capital requirements, on a forward-looking basis In CP08/24 we proposed amendments to our Handbook text to make it clearer that to comply with the overall Pillar 2 rule as set out in GENPRU , firms must satisfy the general stress testing requirement set out in GENPRU R We proposed inclusion of additional text in order to provide additional guidance to firms on stress and scenario testing including clarity on appropriate mitigating management actions, severity of stresses and consideration of how risks may combine We also sought to clarify our expectation that, in general, BIPRU firms should hold sufficient capital now to meet their overall financial adequacy rule (GENPRU R) in the face of a stress scenario, after allowing for realistic management actions We asked: Q9: Do you have any comments on the proposed changes to the general stress and scenario testing rule and additional guidance to firms? 2.66 The industry response to the question on our general stress testing requirements under Pillar 2 was largely favourable, as respondents welcomed the proposed additional guidance. We are taking the opportunity in this document to comment fully on the extensive responses received Generally, respondents suggested a need for further guidance or clarification. Firms, especially larger, more complex firms, were keen to understand more about the severity of stress that we view as appropriate for the capital planning stress test and to understand better our approach to combining a sudden market-type shock with longer-term economic decline. The terminology proposed in CP08/24 of a one in 25 years event was also questioned in terms of clarity and whether it referred to historical experience or not. Respondents also queried whether expected severity would move further out in a cyclical downturn or whether the severity of the scenario is supposed to be defined from a cycle-neutral position Respondents considered that it was important for our stress and scenario testing requirements to be applied proportionately, i.e. having regard to the nature, scale and complexity of the risks borne by firms as well as being aligned to the risk appetite of the firm. In particular, they considered that appropriate recognition should be given to differences in the nature of banking and insurance businesses and between proprietary and mutual organisations. They also considered that we should be proportionate in our review and challenge of the stress and scenario testing performed by a firm Some respondents suggested that more prescriptive guidance from supervisors, such as a range of commonly prescribed scenarios and guidance on the extent to which risks should be assumed correlated in a stress situation would assist them in designing scenarios. 8 A cycle-neutral position describes an average point through the economic cycle. Financial Services Authority 23

26 2.70 The extent to which we would allow the impact of management actions to mitigate a stress to be taken into account, and particularly whether group support would always be regarded as a management action, was another point on which clarification was sought Some respondents queried how our approach would be co-ordinated with other regulators to assist internationally-active firms in facing a consistent approach in home and host jurisdictions A number of participants from a wider variety of firms wanted to understand how the explanations for Pillar 2 stress testing outlined in CP08/24 fitted in with other revisions to stress testing approaches and, in particular, how the stressed value at risk (VaR) requirements envisaged in trading book amendments and the severe stress test envisaged in our enhanced liquidity regime One respondent considered that the statement in the proposed GENPRU R(3) was not clear without quantifying or stating more explicitly a confidence level/probability. Our response: We note the broad support for our proposed changes to the general stress and scenario testing rule and the additional guidance that we incorporated into the Handbook text. To address the range of comments received to this question, and to help firms undertake better stress tests, in this section we outline: good practice in building an effective stress testing infrastructure; the appropriate severity of scenarios and how supervisory recommended scenarios can help in this regard; a description of how scenarios might interact with the economic cycle; our approach to assessing the credibility of management actions; how our requirements link with international regulatory developments; the link with a future macro-prudential regime; and specific guidance for insurers. 24 PS09/20: Stress and scenario testing (December 2009)

27 Building an effective stress testing infrastructure Although our proposed changes to the Handbook and additional guidance are intended as clarifications for firms in respect of stress and scenario testing, it is vital that firms take ownership and responsibility for stress and scenario testing in their organisation and fully embed it in their risk management and strategic decision-making. Our decision to use high-level requirements with supporting guidance is designed to ensure that the onus is on firms to identify their material risks and the accompanying scenarios that are appropriate for their business and risk profile. In order for stress testing to be effective, it is important that firms undertake it properly. In Annex 3, we set out and remind firms of our expectations on the governance of stress testing, and good practice in establishing an effective stress testing infrastructure. Some of the key points highlighted in the annex are that: 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 robust stress testing programme covering all relevant levels of its business, all risk types and over a range of severities; and firms should establish a robust stress testing infrastructure with appropriate IT systems and resources in place, which should be periodically reviewed by senior management for its continued effectiveness. Severity of scenarios We rearticulate here our view of the appropriate degree of severity that firms should apply in constructing stress scenarios for the Pillar 2 capital planning stress test. Firms should also note that from time to time, we may recommend scenarios to be applied directly in the ICAAP or ICAS of specific firms or that, more generally, can serve as an informative adverse scenario to guide firms calibration of their own scenarios, and as an indication of appropriate severity (as a result, we refer to this as an anchor scenario). For further details, see the box below on supervisory recommended scenarios and also Annex 6. Applying an appropriate degree of severity to stress scenarios is not sufficient in itself to ensure the effectiveness of a stress test. An effective mechanism to translate macroeconomic parameters into specific effects on a firm s risk parameters is equally important. Nonetheless, severity is important and the definition of appropriate severity has attracted significant debate in 2009, as expectations and understanding of a severe yet plausible scenario took account of experience through the recent market turmoil. As outlined in CP08/24, in our analysis of firms stress tests undertaken before that turmoil, we observed that firms did not consider sufficiently severe scenarios. Financial Services Authority 25

28 UK recessions, Peak to trough fall in real GDP (%) Mean of firms' Pillar 2 scenarios (to date) Sources: Maddison ( ); ONS ( Q3 2009); selected major firms' ICAAPs ( ) In CP08/24 we consulted on the idea of extending the BIPRU provisions, asking a firm to assess the effects of an economic recession of a severity experienced once in 25 years to the more general GENPRU R stress testing requirement. However, we have observed that the once in 25 years terminology has been widely misunderstood in the following ways: it led to a simple repetition of recent experience such as the downturn of the early 1990s; it caused confusion with quantitative confidence intervals referred to in supervisory requirements; and in the recent downturn, claims that we are now beyond a once in 25 years experience led to suggestions that firms did not need to undertake further stress tests (see the box below on Scenarios and the economic cycle ). Accordingly, and based on respondents concerns about potential misunderstanding of the once in 25 years terminology, we intend to remove the once in 25 years guidance from our Handbook text. Instead, we have amended various provisions in the Handbook text in accordance with the guidance set out below. Our rearticulated guidance on severity In their Pillar 2 capital planning, firms should consider a range of scenarios. They should include a severe downturn scenario based on forward-looking hypothetical events that are calibrated against the most adverse movements in individual risk drivers experienced over a long historical period. Our Handbook text will be amended to reflect this revised approach. For example, a firm might identify a combination of a fall in equity prices, an interest rate shock in an adverse direction and an extended downturn in GDP as relevant for its risk profile. The exact combination of these circumstances should be considered in the light of current and hypothetical circumstances including possible second-order effects. However, the severity 26 PS09/20: Stress and scenario testing (December 2009)

29 of movements in those risk drivers should be internally consistent and calibrated to relevant long-run historical experience The graph below illustrates that simple reference to experience in the twenty five years to 2007 would not give an appropriate view of severe stress. UK macroeconomic indicators ( ) Unemployment Max RPI inflation Max UK Base rate Max GDP Min % Period Our re-articulation is not designed to directly require firms to undertake a more severe stress test, but is intended to address misconceptions that arose from the once in 25 years terminology. For example, looking at the 25-year segments preceding 2007, the worst GDP fall over any 12-month period was -1.8% whereas over a longer historical period of 175 years, the average 25-year downturn in GDP over any 12-month period was significantly more severe. We acknowledge, however, in light of recent experience that in practice firms are likely to find that their scenarios are more severe than in previous years. We also intend to assist firms in formulating scenarios by recommending supervisory scenarios that can be applied directly in the ICAAP or ICAS in the case of specific firms or can be applied more generally as an informative adverse anchor scenario that would serve as an indication of appropriate severity against which firms could calibrate their scenarios. Other considerations In addition we expect firms to consider how the chosen scenario: addresses all material risk types and factors relevant to the institution this mainly means credit risk, market risk, operational risk, interest rate risk and liquidity risk as appropriate, but this is not exhaustive; addresses institution-specific vulnerabilities, including regional and sectoral characteristics and specific product or business-line exposures and concentrations; considers a confluence of events and in particular, the possibility that a sharp market shock may be followed by a prolonged period of economic decline; Financial Services Authority 27

30 contains a scenario narrative that includes various trigger events where appropriate, which could include monetary policy, financial sector developments or triggers, such as commodity prices or even political events and natural disasters; is forward-looking over the same period as the ICAS/ICAAP; captures the most severe elements and probability of occurrence that an institution expects to survive it should be a serious but not fatal scenario related to a firm s stated risk appetite in a meaningful and consistent way and tested for resilience in relation to that risk appetite; and considers dynamic feedback effects and second-order effects of Pillar 2 risks with each other. We have provided guidance in the Handbook in this regard but ask firms to consider the potential impact of second-order effects in their stress testing (for example, liquidity risk resulting from operational failure of a counterparty from whom the firm was expecting funds). There is a clear difference between the scenarios used for capital planning and those that are realised as a result of firms reverse stress-testing. However, we note that firms may find the analysis from the reverse stress testing is a useful tool in assessing the content and severity of their capital planning stress. Supervisory recommended scenarios While the responsibility for scenario selection should rest with firms senior management, our experience during the recent crisis has been that there is value in assisting firms through the identification of supervisory recommended scenarios as a complement to firms own scenarios. In this context we noted respondents feedback in relation to the merits of scenarios recommended or set by supervisors. We remain cautious about prescribing scenarios through the Handbook but do see a role for us to recommend scenarios to firms from time to time. We have added guidance in relation to this in GENPRU BG. Setting a supervisory recommended scenario will involve the formulation of macroeconomic and/or financial market scenarios. We intend to publish the high level parameters of our recommended scenarios externally. We are mindful that introducing supervisory recommended scenarios requires taking a proportionate approach, particularly taking into account that different types of firm are exposed to and affected by different risks. One way of accounting for these differences is for supervisors to formulate a macroeconomic scenario that reflects relevant supervisory concerns. Generally we would expect firms to use this scenario as an adverse anchor in the development of their scenarios. The adverse anchor scenario could then be used as the basis for firms to create their own scenario that tests firm-specific vulnerabilities and that is appropriate and consistent with their individual types of business. In some cases we may require specific firms to run this scenario directly as an input to their ICAAP/ICAS. It may also be the case that we run our own supervisory stress testing in addition to firms stress testing. Where the FSA undertakes its own stress testing analysis using these scenarios, we will use our results to assess firms against minimum specified capital levels. 28 PS09/20: Stress and scenario testing (December 2009)

31 Separately from the capital assessment process, we are also interested in understanding the systemic implications of stresses on individual firms. To achieve this, in future we may also request groups of firms to run a common recommended scenario simultaneously in order to gauge potential system-wide stresses, including first and second round systemic effects. In addition to providing more clarity to firms about what is considered to be an appropriately severe stress, we recognise that there can be additional benefits in recommending scenarios to firms. In particular, using supervisory recommended scenarios can encourage: engagement of senior management firms awareness of the reputational considerations associated with undertaking stress testing exercises that include reporting of management actions are likely to result in senior management being better engaged in the stress testing process; overcoming disaster myopia as we have already stated in CP08/24, before the recent market turmoil, firms tended to underestimate the probability of adverse outcomes and crystallisation of tail risks (one way of addressing this is for supervisors to recommend a sufficiently severe scenario for firms that represents such a tail event ); and benchmarking of results and approaches as well as gauging systemic issues, asking groups of firms to run a common scenario stress test simultaneously will allow supervisors to more easily compare and benchmark individual results and firms approaches to stress testing. Scenarios and the economic cycle The feedback received to CP08/24 indicated that firms would like additional clarity on how scenarios used for Pillar 2 capital planning purposes should change with the economic cycle. Our intention for the Pillar 2 stress test is that scenarios should, as a starting point, reflect the most severe but plausible worst-case scenarios through which we expect firms to maintain minimum specified capital levels. We do not intend the scenario to be procyclical and therefore we expect it to reflect the position of the cycle at the time it is set. However, on a practical basis we do expect scenarios to be updated to reflect new macroeconomic information such that firms are always stress testing against a plausible worst-case scenario and therefore, absolute countercyclicality in the scenario would be undesirable. Thus, whilst the Pillar 2 scenario should not simply be a fixed percentage change from a particular point in time (e.g. GDP should always fall by X percentage points regardless of the point of the economic cycle we have reached) it will change with experience. Even at the trough of a cycle, we would not expect the stress scenario to be less severe than the current baseline forecast and effective stress testing requires that scenarios reflect a potential downside from an already difficult position. However, scenarios should not automatically become more severe during a downturn and less severe in an upturn. Financial Services Authority 29

32 Management actions In CP08/24 we set out our approach to assessing the credibility of management actions taken to mitigate a stress. In particular, parental support in time of stress would be viewed as an unlikely event in the absence of clear legal certainty. We have been asked to clarify this position and better define what we mean by legal certainty. We retain our view that, in general, we would exercise a degree of caution when reviewing the likely effectiveness of management actions. Firms must consider their management actions in the context of how their scenario interacts with the system as a whole rather than in isolation. Assumptions about actions such as capital-raising and the disposal of assets would all be affected by the external environment and the actions of others. Recent experience has also highlighted the importance of firms having credible and feasible management plans allowing for potential difficulties in executing assumed actions in a stressed situation. It is important to distinguish between management actions in normal circumstances and management actions that could be relied upon were the stress scenario to develop. We take a conservative approach in relation to guarantees or commitments of parental support as an acceptable management action in the context of capital planning and any associated capital planning buffers. Only in exceptional circumstances would we be prepared to consider accepting parental support as a mitigating tool or action. In those cases, the onus is on firms to demonstrate that the parental support arrangement is legally enforceable, effective, credible, and will be forthcoming in stressed conditions i.e. the parent will not itself be under such stress that it is unwilling or unable to effect the transfer of capital to its subsidiary. International co-ordination We are working with colleagues in both EU and international committees to find common ground on supervisory approaches to stress testing. The Basel Committee has released its principles on stress testing in May 2009 (see Annex 5). We are working with the Committee of European Banking Supervisors (CEBS) in developing proposals for best practice principles on stress testing to be released in late Our requirements for stress testing under Pillar 2 for insurers will also be a reference point as we discuss within CEIOPS possible development of implementing measures and guidance for the Supervisory Review Process and ORSA under Solvency 2 as far as stress testing is covered.the International Association of Insurance Supervisors (IAIS) has also been developing its guidance on stress testing for insurers in light of the financial crisis. 30 PS09/20: Stress and scenario testing (December 2009)

33 Links with macro-prudential approaches The Turner Review 9 published in March 2009, sets out our thinking on possible system-wide approaches to identifying and dealing with macro-prudential risks, to complement our micro-prudential supervision of individual firms. With specific reference to Pillar 2 stress testing, firms should note our view that there is a clear difference between idiosyncratic capital buffers currently set and any future system-wide measures. We also think it is important that analysis is undertaken at firm and system-wide levels. However, we are aware of the need for consistency and the potential for double counting and will be cognisant of these issues going forward. Insurers 2.74 Insurers, in particular, while supporting our proposals, did not regard them as simply a clarification but rather an extension to the range and number of stress and scenario tests required of them which would also involve some development of modelling. One insurer considered that the greater emphasis on longer-term stress testing in our proposals should be made clear to firms through a Dear CEO letter Some insurers requested clarification and distinction of the relationship between our general stress testing requirements in GENPRU R, those for insurers ICAS in INSPRU 7 and the reverse stress-testing requirements. It was suggested that there should be a more explicit distinction between reverse stress-testing and other types of stress testing Another insurer suggested a need to articulate the relationship between our proposals and the principles underlying the Own Risk and Solvency Assessment (ORSA) due to be introduced under Solvency 2, to avoid duplicated effort and differing messages in the development of the longer-term regulatory framework for insurers. Insurers We accept that changes to GENPRU R represent a strengthening of general stress testing requirements for insurers. While this strengthening brings the requirements for insurers and BIPRU firms more into line, the requirements are principles-based and require an appropriate range of adverse circumstances to be identified for each firm. They do not require tests and analyses that are appropriate only for BIPRU firms to be applied to insurers. We agree that it is important that our requirements be effectively communicated to firms. The general stress and scenario testing rule GENPRU R is separate from the insurers ICAS requirements in INSPRU and also separate from the reverse stress-testing requirements in SYSC 20. The general stress and scenario testing rule is part of ensuring a firm has sound, effective and completed processes, strategies and systems to manage its risks and financial resources. The ICAS is an assessment of current capital adequacy and is one of the assessments required by GENPRU R for which principles-based rules and guidance is set out in INSPRU 7. The changes to GENPRU R do not impact the ICAS requirements for insurers. It is not a 9 As set out in DP09/2: A regulatory response to the global banking crisis published on 18 March Financial Services Authority 31

34 requirement of the ICAS to use stress testing, but it is often used in practice. This distinction is made in the updated guidance in INSPRU 7.1.9AG and G. However, if a firm uses stress testing and scenario analyses in its ICAS, it should take these into account when carrying out the stress tests referred to in GENPRU R. For specific details on the reverse stress-testing requirements as they apply to insurers, see questions three to five. Our requirements for stress testing under Pillar 2 for insurers will be a reference point as we discuss within CEIOPS possible development of implementing measures and guidance for the Supervisory Review Process and ORSA under Solvency 2, should stress testing be covered. We have provided further information for insurers in Annex 4 on our expectations relating to capital planning stress tests. Other issues We note that firms would like to understand better how Pillar 2 stress testing, as outlined in CP08/24, links with other stress testing approaches, in particular within the new liquidity regime set out in PS09/ We address this in Section 3 of this PS. The Handbook text proposed in CP08/24 has also been amended in light of the consultation responses to make it clear that it is the nature, scale and complexity of the risks borne by a firm as well as the scale and complexity of its business that needs to be assessed in determining a proportionate approach to stress and scenario testing. We recognise that there are important differences between banks, insurers, proprietary and mutual organisations that need to be reflected in their risk management. These differences will also be taken into account when evaluating the feasibility of management actions. Our supervision of stress and scenario testing will also be risk-based and proportionate We asked: BIPRU firms Q10: Do you have any comments on our requirements that in general firms should hold capital now against the overall financial adequacy rule, including in a stress scenario after allowing for realistic management actions? 2.78 Respondents broadly agreed with our proposed restatement of capital outcomes associated with the Pillar 2 stress testing requirement for BIPRU firms. (We have strengthened BIPRU 2.2 by stating that an effective capital plan should be identified and, taking into account appropriately realistic management actions, an additional capital buffer should be held now but would be available to absorb losses or to meet higher capital requirements in adverse external circumstances, in order to meet the overall financial adequacy rule in a stressed scenario). Respondents questioned whether this was a clarification or a change in our requirements and requested further guidance on when and how we would expect idiosyncratic capital buffers in a firm s ICG to be drawn down during an economic downturn. 10 PS09/16: Strengthening Liquidity Standards including feedback on CP08/22, CP09/13, CP09/14 32 PS09/20: Stress and scenario testing (December 2009)

35 2.79 Respondents considered that the proposal in paragraph 3.56 of CP08/24 to hold capital to cover both market and credit risk may be overly prudent as it suggests the correlation between these risks is 100%. They suggested that a better approach would be for us to justify a strong correlation factor across the two risks. Another respondent said that it was not entirely clear whether the rule requires Pillar 2 capital to be calculated assuming stress events have crystallised. Our response: We note that firms accept our requirements that, in general, firms should hold capital now against the overall financial adequacy rule, including in a stress scenario after allowing for realistic management actions. We included text in CP08/24 related to capital outcomes associated with the Pillar 2 stress test for BIPRU firms in order to help them better understand our existing approach. This is not a change in our requirements. We recognise that firms would like to understand better how this buffer will be drawn down during adverse external circumstances. To that end, we are publishing a short Consultation Paper (CP09/30) to accompany this PS to explain our approach to the capital planning buffer and create a more explicit mechanism for drawing down this buffer in adverse external circumstances. We note that in times of stress, correlations between risk factors can move significantly in an adverse way. 11 If a firm assesses market risk and credit risk separately then our presumption would be that it holds capital against both risks separately. However for stress testing purposes, if firms use an integrated scenario that includes both risks so that it leads to integrated stress testing outcomes, our approach allows firms to identify appropriate correlations between risk types. However firms should adopt appropriate conservatism in this regard. Market risk BIPRU firms 2.80 CP08/24 highlighted that recent events had demonstrated a high correlation (and contagion) between different positions, risk types and markets. Firms had not taken account of such a likelihood in their stress testing for market risk and we sought to clarify our rules and guidance to steer firms in the right direction We asked: Q11: Do you agree with our proposed clarification of the use of stress testing for market risk purposes? 2.82 Respondents largely supported the proposed clarification of the use of stress testing for market risk purposes. However, it was suggested that we should clarify the application of the requirements to firms that did not have CAD 2 model recognition Financial Services Authority 33

36 Insurers 2.83 Insurers also asked for clarification of how the proposed requirements would apply to them. Our response: The market risk stress testing rules and guidance are intended to strengthen risk management practices for all firms that have market risk positions and should be considered as part of the Pillar 2 capital assessment. One of the key reasons for making these changes is to ensure that those firms that do not have a VaR model permission are subject to explicit requirements to stress market risk positions under Pillar 2. We consider that all firms with market risk should have the capability to undertake effective stress testing for trading portfolios that is proportionately based on the size and complexity of the firm s market risk positions. Firms with a VaR model permission tend to have more complex trading books and their stress testing should reflect this. Indeed, the requirements that firms must satisfy to receive model recognition already include a rigorous programme of stress testing. In summary, our proposals should ensure that all firms have adequate stress testing in place for market risk. Where a firm is not already subject to a programme of stress testing for market risk (i.e. because it does not have a VaR model permission) this will in future be required under specific rules and guidance in BIPRU 7.1. Firms with a VaR model permission are already subject to the stress testing requirements in BIPRU 7.10, which have been improved, but these should now be considered in the context of the new general requirements of BIPRU 7.1; for example we would expect the good practices outlined in Annex 3 to be relevant for all firms, whether they have a VaR model permission or not. Insurers The proposed amendments to the Handbook relating specifically to market risk stress tests apply only to BIPRU firms (not insurers). The rules and guidance that will apply to insurers in respect of stress testing and scenario analysis and market risk are in the revised GENPRU 1.2 and in SYSC 16. Further information on stress testing for insurers was published in the Insurance Sector Briefing: Risk and Capital Management in September However, some of the more general raising of standards for stress testing applies to both insurers and BIPRU firms. Some of these are relevant to the market risk stress tests already required by SYSC for insurers. Interest rate risk in the non-trading book BIPRU firms 2.84 In CP08/24, we stated that it would be helpful to signal more clearly specific risks that we feel should receive particular attention. Accordingly, we proposed a change to BIPRU G (1). 34 PS09/20: Stress and scenario testing (December 2009)

37 2.85 We asked: Q12: Do you agree with our proposed amendment to our stress testing guidance for interest rate risk in the non-trading book? 2.86 Respondents were largely supportive of our proposed amendment to our stress testing guidance for interest rate risk in the non-trading book. However, it was considered that risks should only be stressed if they were material and respondents suggested changes in wording to improve clarity. One respondent expressed concern that any additional reporting requirements might lead to increased costs and another that the issues might be better addressed through an industry briefing. Our response: We note that, broadly, firms were supportive of our proposed changes in the description of certain types of risk and we will now implement those changes. Regarding materiality, firms will need to be able to satisfy us, by demonstrating to an appropriate level of detail, why a particular risk is not regarded as material and so need not be stressed. In seeking to understand further the implications of interest rate risk in the non-trading book we may on a case-by-case basis ask firms to submit additional information to us. We may apply our own stresses to the data and we believe that engaging with firms in this way it will help them gain a clearer understanding of our expectations. Securitisation 2.87 We stated in CP08/24 that funding from securitisation could not be relied upon as a matter of course. In the market turmoil, firms experienced several difficulties, including closure of the securitisation markets; higher funding costs; provision of additional support to off-balance sheet structures; the unwinding of securitisations as triggers were met; and pipeline transactions not being completed. It is evident that many financial institutions did not fully understand the risks associated with their securitisation activities and the potential firm-wide impacts in stressed market conditions. Where securitisation is a material source of funding there can be an impact on credit risk, concentration risk, counterparty risk, market risk, liquidity risk and reputational risk So, when performing stress testing, we proposed that firms should consider the potential firm-wide impacts of their securitisation activities and other off-balance sheet exposures in times of stress. We therefore proposed to add additional guidance at GENPRU 9.1.8AG to reflect this. Stress testing of securitisation should take into account both existing securitisations and pipeline transactions, as there is a risk that the former will be supported due to reputational concerns and the latter transactions will not be completed in stressed market conditions. We would expect that the risks associated with securitisation form part of a regular programme of stress testing undertaken by firms. The results of the stress testing must be communicated to senior management and appropriate action should be taken. This could include mitigation of risks identified, seeking alternate sources of funding or changes to a firm s strategy. Financial Services Authority 35

38 2.89 We asked: Q13: Do you agree with our proposed amendment to our stress testing guidance for securitisation? 2.90 Respondents to this question were supportive of the proposal and agreed with the need to focus attention on the wider risks and implications of securitisation activities One respondent noted the proposals should be cross-referenced to the Basel Committee proposals and Article 122a of the Capital Requirements Directive (CRD), especially the grandfathering clause. Our response: We note that respondents agreed with our proposed amendment to our stress testing guidance for securitisation and we will proceed with our proposal in the final text. We recognise that the requirements in Article 122a impose specific requirements for firms to perform regularly their own stress testing of certain securitisation positions. Implementation of those requirements will be consulted on separately. Stress tests of securitisation exposures that are carried out to comply with BIPRU 9 (which is being amended to implement Article 122a) will contribute to meeting our requirements under Pillar 2. However, they are not likely to be sufficient. For example, we would expect firms to conduct stress testing on all securitisation positions, including existing positions, to determine the firm-wide impact of those exposures. Firms should also note, as outlined by one respondent, that the Basel Committee has introduced proposals to strengthen banks stress testing practices, as well as improve supervision of those practices under the Basel 2 framework. Pension obligation risk 2.92 In CP08/24, we proposed additional guidance in GENPRU for both BIPRU firms and insurers to clarify the fact that for Pillar 2 purposes, a firm should take account of both the direct impact of adverse scenarios on the firm s own business and the knock-on consequences for the firm, if any, of a resulting pension scheme deterioration We asked: Q14: Is our explanation of how estimates of pension obligation risk are impacted by other stress tests sufficiently clear? 2.94 Most of the respondents felt that our explanation and additional guidance in our Handbook in relation to pension obligation risk was sufficiently clear. However, a number of respondents suggested that additional clarity over our expectations about pension obligation risk, including its treatment in Pillar 2 capital modelling, and mitigating management actions in a stressed scenario would be helpful Respondents also asked us to take to take a proportionate supervisory approach in relation to the treatment of pension obligation risk, taking into account the materiality of pension risk to different types of firms. 36 PS09/20: Stress and scenario testing (December 2009)

39 Our response: We note that respondents are broadly content with the additional guidance we have included in the Handbook in relation to pension risk. We acknowledge that firms would welcome greater clarity on our expectations and approach to calculating Pillar 2 pension risk capital. We are working on this and plan to communicate in H further details to firms and trade associations about our approach in this regard. Simple BIPRU firms 2.96 We proposed an additional text in our Handbook to clarify our requirements in relation to stress testing for BIPRU firms whose activities are simple. We included clarification about our definition of firms with simple activities and also provided guidance about our expectations for appropriate and proportionate stress testing by these firms We asked: Q15: Do you have any comments on our clarification of the Handbook text for BIPRU firms whose activities are simple? 2.98 A number of respondents expressed concerns that additional guidance meant that for firms to be considered as simple, they would have to be assessed as small. Respondents considered that such an approach would be disproportionate, particularly for limited licence firms who undertake simple activities Respondents suggested that all limited licence firms be considered as simple regardless of their size, so they are exempt from certain requirements that are applicable to complex firms One respondent suggested that we should consider information-sharing and coordination with other supervisors in respect of this point, with the intention of easing the requirements for simple firms that may be branches or subsidiaries of larger, more complex firms. Our response: We note the concerns raised by respondents in relation to requirements for BIPRU firms whose activities are simple and acknowledge the importance of taking a proportionate approach to such firms in relation to stress testing. We adopt a principle of proportionality in our assessment of firms stress testing, requiring firms to use a level of sophistication in their stress testing that is commensurate with the nature, scale and complexity of their business and the risks that they face. Therefore, we emphasise that for firms that are both small and simple, stress testing may primarily be a qualitative exercise involving a significant amount of engagement by senior management. It does not necessarily involve detailed modelling. It is equally true that we would expect larger and more complex firms to take a more structured and comprehensive approach to reverse stress testing is expected. However, consistent with our approach we may require simple firms that are larger in size to undertake stress testing to a higher level of sophistication than we would expect firms that are both small and simple to use, reflecting the risks to which they are exposed and their potential impact. Financial Services Authority 37

40 Group risk In CP08/24, we stressed the importance that group risk be included explicitly in the list of major risks. In particular, we are keen the firms include group risk in their stress testing. For example, we expect firms stress testing to take into account the risk that a group may have to bring off-balance sheet activities back onto its balance sheet as a result of reputational contagion, even if there is the appearance of legal risk transfer. As a result of the stress, mitigating actions should be considered such as holding additional capital resources at the solo and/or group levels We also stated that firms should include group risks in their stress testing including any relevant and appropriate actions, including holding additional capital resources at the solo and/or group levels. In particular, we expected firms stress testing to take into account the risk that a group may have to bring off-balance sheet activities back onto its balance sheet as a result of reputational contagion, even if there is the appearance of legal risk transfer We proposed changes to our Handbook text to reflect the points above: Insertion of group risk in the list of major sources of risk along with guidance about what we mean by group risk. Inclusion of further guidance on stress testing of group risk. Inclusion of guidance in SYSC G to clarify that stress and scenario analyses of group risk will form part of risk management processes and internal control mechanisms We asked: Q16: Do you have any comments on the proposed amendments to our group risk Handbook text? Most firms agreed with our proposal to include group risk in the Pillar 2 risks and to require group risk stress testing. But respondents highlighted concerns about proportionality and practicality. A number of respondents commented on what they thought were potential stumbling blocks to the practical application of the group risk guidance (GENPRU G to G) One respondent considered that group risk was already adequately defined by our existing rules; while another said that it should be considered where relevant. One respondent argued that the awareness required to fulfil the requirements of the draft group risk guidance would be difficult from a practical point of view and suggested that we qualify the guidance with a proportionality clause For example, some firms queried whether the guidance would require each legal entity to conduct an audit of its parent to ensure it can continue to support it, stating that it would be impracticable to expect a UK subsidiary of an international group, in order to determine the extent of its exposure to group risk, to have access to the required information/analysis to be able to audit its parent and wider group. They argued that the guidance could create the impression that we wished to audit groups risk profiles and risk management capability though the back door via oversight of their subsidiaries. 38 PS09/20: Stress and scenario testing (December 2009)

41 Another respondent felt that the guidance should be more flexible by giving firms the discretion about whether stress tests are carried out on a solo, business line or group basis On our general approach to stress testing, one respondent said that we should be mindful of the international dimension so as not to be inconsistent with developments elsewhere, noting possible competitiveness issues that may arise as a result of taking a tougher stance than other supervisors. For example, where stress tests lead to firms needing to hold additional capital, respondents argued that it may restrict a firm s ability to manage capital effectively, stifle competition and adversely affect the UK economy On our proposed guidance that firms should consider whether off-balance sheet assets and liabilities could be brought back on balance sheet for reputational reasons, some respondents suggested that this should be qualified on the ground of materiality. Respondents also noted that the proposal may be difficult to implement in practice due to problems in obtaining information for securitisations where all of the risk has been transferred. One respondent wanted firms to be given discretion to make judgements about when and how to do the analysis suggesting that primary stress testing should be done at the consolidated group level, wary of how meaningful detailed stress testing at solo UK level could be. Our response: We note the general acceptance of the importance of group risk but also note the reservations expressed about the practicability of compliance with the group risk guidance, for instance, as it applies to UK subsidiaries of large, international groups. We agree on the need for proportionality and, in the specific context of group risk stress testing, the draft Handbook text in CP08/24 provided that stress tests and scenario analyses should be carried out to a degree of sophistication commensurate with the group s complexity and the nature of its group risk. In our view, this adequately captures the flexibility required to accommodate the differing nature of individual group structures. In respect of the comments about capital management, it is important that firms note that their objectives in relation to capital management and allocation may not necessarily be the same as regulatory goals in that context. We consider that holding adequate capital within a solo entity is fully consistent with our objectives as the benefits of group membership aside it is individual solo entities that may become insolvent. So, it is possible that the amount and quality of capital that we may consider appropriate to hold against the risks of an individual firm may not be considered optimal (from a capital management point of view) by the firm itself. In response to the comment about perceived threat to competition and the UK economy, the recent crisis has shown that inadequate levels of capital pose an even greater threat to the UK economy in the form of consumer detriment, systemic crisis and the collapse of market confidence. We acknowledge the importance of working collaboratively with other national authorities to ensure a consistent regulatory approach across borders. We will also be working with home regulators of large international groups that have subsidiaries in the UK. Financial Services Authority 39

42 Group systems In response to firms concern about indirect audits of group risk management capability, firms should note that we see group risk as arising at both solo and group levels. The provisions in SYSC 12 set out a firm s obligations to have adequate, sound and appropriate risk management processes and internal control mechanisms for the purpose of assessing and managing its own exposure to group risk on solo and group bases. We believe a firm should be mindful of its exposure to group risk via financial linkages (such as intra-group exposures) with other related entities. It should also be mindful of its vulnerability to a more general group-wide event that is broader than something resulting from for example, a particular intra-group transaction. Off-balance sheet items In respect of off-balance sheet items, we consider that a group must be able to assess how items that are off-balance sheet may nevertheless impact it in future. Whilst the principle of proportionality applies, we do not consider that setting a specific materiality threshold would be helpful (see the draft guidance in GENPRU G). 40 PS09/20: Stress and scenario testing (December 2009)

43 3 Reverse stress-testing Scope of application 3.1 Our reverse stress-testing requirements will apply to all banks, building societies, insurers and some BIPRU investment firms. 3.2 In light of feedback we received to proposals in CP08/24 relating to the proportionality of applying quantitative stress testing standards to BIPRU investment firms, we clarify that, as with other aspects of risk management, reverse stress-testing should be implemented proportionately. So, smaller, less complex organisations would be expected to conduct less complicated reverse stress-testing, possibly more qualitative than quantitative, but larger, more complex organisations will need to conduct more extensive stress testing, which will be both qualitative and quantitative in nature. 3.3 We also recognise that our existing requirements on some investment firms to undertake an analysis of orderly wind down would result in them duplicating work if we were to ask them to comply with the reverse stress-testing requirements. Please see our response to question five for further details on our approach to the scope of the reverse stress-testing requirement. We will keep the segmentation criteria under review. 3.4 The design and results of a firm s reverse stress-test must be documented, reviewed and approved at least annually by the firm s senior management or governing body. However, we would require a firm to update its reverse stress-test more frequently in light of substantial changes in the market or in macroeconomic conditions. Implementation timetable 3.5 Those firms subject to the reverse stress-testing requirement (please see our response to question five) will have 12 months from publication of this PS (14 December 2010) before the requirements become effective. 3.6 We believe that it would be valuable for firms to start thinking about the new requirements at an early stage and therefore we will be requesting firms to produce and send to us, an implementation plan detailing how they plan to incorporate reverse stress-testing into their current suite of risk management tools. By developing a realistic and actionable implementation plan, firms should be in a strong position to undertake a reverse stress-test as soon as the requirement becomes effective. Financial Services Authority 41

44 3.7 We plan to issue, in the first quarter of 2010, a short implementation template which we ask firms to complete and return by June We believe there is value in providing additional assistance to firms regarding the new requirements and our expectations of how they would work in practice, as they develop their implementation plans. We intend to share good practice via our website. We will provide examples of approaches to reverse stress testing and our view of how it is integrated into a firm s suite of stress tests. In addition between January and June 2010, we plan to run a series of reverse stress-testing surgeries with firms. Links between reverse stress-tests and other stresses 3.8 In response to questions about how different components of our stress testing requirements fit together and in particular following the recent publication of the PS on liquidity stress testing (PS09/16: Strengthening Liquidity Standards, October 2010), we have included a short section in this PS outlining potential links between Pillar 2 stress testing, liquidity stress testing and reverse stress-testing (see also Annex 6). 3.9 With regard to Pillar 2 stress testing, there is a clear difference between the objectives and scenarios used for capital planning stress testing under Pillar 2 and those that are identified as a result of firms reverse stress-testing. However, we note that firms senior management may find the analysis from reverse stress-testing, in particular, the scenario that could cause a business model to fail, to be a useful tool in assessing and challenging the content and severity of the capital planning stress scenario under Pillar With regard to stress testing in the individual liquidity adequacy assessment (ILAA), we see complementarities between this and reverse stress-testing. The ILAA stress that a firm is required to consider (as described in in PS09/16) in order to estimate the resulting amount of outflows that it could incur and calculate the size of its liquidity buffer, is a combination of an idiosyncratic liquidity stress and a market-wide stress. The idiosyncratic stress typically arises as a consequence of well or ill-informed external perceptions about the underlying solvency of the firm, whereas the market-wide stress would crystallise as a result of external factors, independent of the particular situation of the firm When a firm is looking at liquidity scenarios that would cause its business model to fail, the market-wide ILAA stress can provide a useful insight into its reverse stress-testing analysis. Where a firm holds only enough liquidity to withstand the market-wide ILAA stress, any market-wide stress that is more severe could lead to the failure of the firm s business model. In addition, as the ILAA idiosyncratic stress typically crystallises as a result of well or ill-made market-based judgements about a firm s underlying solvency position, a firm could as part of its reverse stress-test, identify any potential weaknesses in its business model and use this as an input into its idiosyncratic stress test. 42 PS09/20: Stress and scenario testing (December 2009)

45 Reverse stress-test recovery and resolution plans 3.12 Following the recent publication of the Discussion Paper on the Turner Review Conference (DP09/4: A regulatory response to the global banking crisis: systemically important banks and assessing the cumulative impact) we have included a short section in this PS noting the synergies between the reverse stress-tests and recovery and resolution plans A recovery strategy is about the management of a firm taking actions that are aimed at preventing it from failing in circumstances where it is facing a severe stress. In order to avert failure, management may need to undertake radical options. A recovery plan details what options the management may pursue, what would need to happen for each action to be implemented, and the risks to implementing each action. In this way a recovery plan can build on existing stress and scenario testing requirements (many of which have been clarified in this PS) and on management actions that would be taken in response to these events In a resolution plan, firms will provide the information that would be necessary for the authorities to undertake a resolution of the firm and identify the actions that would need to be taken for the authorities to resolve a failing firm in an orderly manner. Resolution in this context could include either the use of the Special Resolution Regime (SRR) tools (if applicable) or for the firm to be placed into insolvency. This is a separate process to the reverse stress-test which requires a firm to identify and assess the scenarios most likely to cause its current business model to fail and, using its results, put in place appropriate mitigating action. However, the reverse stress-test can be seen as the starting point for resolution plans, as the point at which the risks identified in the reverse stress-test crystallise may be the point at which resolution plans are required. Financial Services Authority 43

46 4 Other points Outreach to industry 4.1 As outlined in CP08/24, we intend to increase our focus on stress and scenario testing and will be expecting firms to continue to improve their stress testing infrastructure as outlined in Annex We will provide information for firms via our external website and we noted in CP08/24 that there would be merit in establishing an expert group. This would have representation from the FSA, the Bank of England and industry to regularly discuss the steps that we expect firms to take to improve their stress testing and the sorts of stresses that firms should consider. In due course, we will communicate more details on how this forum will work. Publication 4.3 There is ongoing debate about the role of public disclosure in relation to different types of stress testing. 4.4 We currently require firms to undertake their own stress tests to enable them to identify, assess and manage the risks in their business activities. If firms were to publish the results of their own stress tests, it could serve as one way of encouraging senior management engagement in the stress testing process, for example in designing scenarios, discussing results and defining any resulting actions. Equally, there are risks in taking such an approach, particularly if firms simply use stress testing as an opportunity to try highlight areas of strength in their balance sheet rather than as a frank analysis of their business vulnerabilities. There are also challenges in ensuring consistency of published stress test results of different firms who have designed different scenarios that test the particular risk drivers that apply to their individual businesses. 4.5 Publication of supervisory stress testing is also a point of discussion. In recent months, regulators both in the UK and overseas have asked firms to run stress tests using specified scenarios. Supervisors have also performed their own stress tests of individual firms using in-house stress testing capabilities. Simultaneous system-wide stress testing will also be used to assess the aggregate effect of particular shock on the system as a whole. Public disclosure of the results of these different types of stress 44 PS09/20: Stress and scenario testing (December 2009)

47 tests would increase transparency and may facilitate consistent comparisons and analysis of individual firms, groups of firms and the system as a whole. However, equally, there are risks and challenges in doing this, which mean that publication may not work in practice. 4.6 We have previously stated our concerns about the publication of our own stress testing results 12 and have not encouraged firms to publish their own stress tests results. Stress tests are a key element in a firm s suite of risk management tools and there could be value in greater understanding about the methodologies used for stress testing. However, stress testing results are most helpful only when viewed with a detailed understanding about the limitations of stress tests and the assumptions therein. Stress test results should not be relied upon in isolation for an assessment of a firm and publication of stress test results may lead to misleading interpretations of the risks in a firm. However we will keep this under review and may consider this further in In an FSA statement on the use of stress tests released on 28 May 2009 which can be found at Financial Services Authority 45

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49 Annex 1 List of non-confidential respondents to CP08/24 AXA UK Aberdeen Asset Management Association of British Insurers Association of Friendly Societies Aviva PLC Bank of England Benedict McHugo British Bankers Association British Private Equity and Venture Capital Association David & Andrea Gulland Skipton Building Society Standard Life The Actuarial Profession The Association of Private Client Investment Managers and Stockbrokers The Building Societies Association The City of London Law Society The Institute of Chartered Accountants in England & Wales Yorkshire Building Society IMS Consulting Risk Consultants Investment & Life Assurance Group Investment Management Association Legal & General Lloyd s Prudential RSA Group Risk Reward Limited Risk Consultants Royal London Group Insurers Annex 1 1

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51 Annex 2 Cost-benefit analysis Introduction 1 This annex contains a revised version of the cost-benefit analysis (CBA) published in CP08/24. We refer interested readers to our analysis published in Chapter 2 of that Consultation Paper (CP). 2 Under the Financial Services and Markets Act 2000, we are required to provide an estimate of the costs and an analysis of benefits of new regulatory proposals. We have made changes in specific areas of the final policy regarding the proposals outlined in CP08/24. Firms indicated in their responses to the consultation that the original compliance estimates might be too low. However, our approach to reverse stress-testing, as with other aspects of risk management, is that it should be implemented proportionately. So, smaller, less complex organisations would be expected to conduct less complicated reverse stress-testing, possibly more qualitative than quantitative, but larger, more complex organisations will need to conduct more extensive stress testing, which will be both qualitative and quantitative in nature. Nevertheless, we decided to revisit our original cost-benefit analysis in the light of feedback received. 3 In this revised version, we only consider the cost-benefit implications of reverse stress-testing requirements. An analysis of the costs and benefits of amendments to Pillar 1 and Pillar 2 stress-testing policy were provided in the original analysis published in Annex 4 of CP08/24. 4 As stated in CP08/24 and in this PS, reverse stress-testing will not have a direct impact on capital requirements. Therefore, we do not consider any cost or benefits that might derive from increasing or decreasing capital levels. This is consistent with the approach adopted in the original CBA published in CP08/24. Policy changes 5 The CBA in CP08/24 was conducted under the assumption that the scope of the reverse-stress test would extend to all banks, building societies and insurers and all BIPRU investment firms excluding BIPRU 50k firms with less than 1bn of funds under management. Annex 2 1

52 6 In light of feedback we received to our proposals, we have decided to amend the final policy in relation to the scope of the reverse stress-testing requirement for investment firms so that it applies only to some BIPRU investment firms that meet the criteria set out on in our response to question five. Costs 7 We have re-calculated our previous incremental compliance cost estimates for investment firms by including in the calculations only those firms under the new scope. Results are shown in Table 1. Table 1: Total compliance costs for all investment firms in scope 000s Investment firms Staff training and recruitment 640 Development of models 900 IT systems and interface 0 13 Senior management review time 160 Board review time 480 Total 2,180 8 The average total compliance costs for firms are now lower than the original estimate for large investment firms published in CP08/24 ( 5.2m) with higher costs for staff, recruitment and the board review time, and lower costs for the other categories. 9 As outlined above, in their responses to CP08/24, firms indicated that the original compliance estimates published in the initial analysis could be too low. Although, we always intended that the reverse stress-testing requirements be implemented proportionately, we gathered additional estimates of the costs of implementing our reverse stress-testing requirements from consultancy firms to assess how representative our previous estimates could be against the real costs to the population of firms. 10 Due to the limited number of responses, we provide average estimates to ensure confidentiality. Estimates are shown provided in Table 2 for each firm. Consultants estimates are high-level and subject to a number of caveats. Development and implementation costs in relation to reverse stress-testing can be expected to vary significantly depending on the complexity and range of business undertaken, as well as the desired sophistication and scope of the stress-testing model. However, we still believe they provide useful and comparable information for CBA purposes. 13 Several surveyed firms indicated that IT costs for reverse stress-testing would be zero. Our estimates published in CP08/24 also indicated that IT costs would be of minimal significance. 2 Annex 2

53 Table 2: Estimated total consultancy costs for firms in scope 000s Small Medium Large Banks Building societies Investment firms Insurers As an illustration, the costs for the total population of firms can be calculated and compared to the figures published in CP08/ As expected, the new cost estimates are, in general, lower than the estimates provided by firms as they do not include board reviewing time or IT systems cost. Total cost estimates for investment firms are also lower than those reported in CP08/24 due to the significant reduction of the number of firms that we envisage will be in-scope for the reverse stress-testing requirement. Overall, we believe these results confirm that those estimates were broadly correct and subject to the relevant caveats, provide a useful indication of the costs arising from reverse stress-testing. 12 We also note that the period of 12 months before the reverse stress-test is implemented will give firms valuable time to develop, update and implement their models with a significant reduction in the expected costs arising from these activities. It will also provide additional time to hire new staff and provide training and, therefore, will reduce cost pressures associated with tight implementation timings. Benefits 13 A complete analysis of benefits arising from the new policy was published in Annex 2 of CP08/24 and our views on this issue remain unchanged. In summary, benefits of a reverse stress-test will arise from the production of a more informed view of a firm s risks and the management consideration of any action to mitigate those risks. 14 Realisation of incremental benefits will only occur if the additional information is used effectively by firms and they fully integrate the outcome of the stress test into their management considerations. Any risk to the realisation of these benefits will be mitigated by our supervisory process. 14 Only includes firms with complex business models. 15 The number of firms affected by the policy was published in our previous CBA in CP08/24 (page 2 of Annex 4). Please note that the final policy includes only approximately 80 investment firms. Annex 2 3

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55 Annex 3 Good practice in stress and scenario testing 1 Stress and scenario testing should be an important element in firms planning and risk management processes, helping firms to identify, analyse and manage the risks inherent within their businesses. It also serves as an effective communication tool internally to senior management as well as externally to supervisors. Incorporating a robust stress and scenario testing framework into a firm s risk management structure can add substantial value by giving senior management additional information about all risks borne by a firm, in particular, in relation to its risk tolerance and strategy in a stress. 2 The importance of stress testing was again emphasised in DP09/2, published in March 2009 simultaneously with The Turner Review, outlining that we regard stress testing as a critical part of our regulatory architecture. The FSA s integrated approach to stress testing 16 consists of three main elements: firms stress testing; FSA stress testing of specific firms; and simultaneous system-wide stress testing (see Annex 6 for more details). We see these elements as interlinked and mutually reinforcing. In this sense, whilst a robust stress testing infrastructure is essential for firms own risk management it also facilitates firms ability to better inform supervisory stress testing and simultaneous system-wide stress testing and allows them to better absorb the outputs and lessons learnt from these exercises such as dynamic feedback effects. 3 This annex sets out and reminds firms of our expectations regarding stress and scenario testing. It draws not only on guidance that we have issued such as the Dear CEO letter issued to banks, building societies and CRD investment firms in 2006, but also on published work undertaken by international groups of supervisors including the Basel Committee on Banking Supervision (BCBS) 17 and the Senior Supervisors Group. 18 We are also actively engaged with the Committee of European Banking Supervisors (CEBS) in developing guidelines on stress testing and this annex covers some of the issues being considered by the Committee in the development of the European-wide guidance. Our requirements for stress testing under Pillar 2 for insurers will also be a reference point as we discuss within CEIOPS possible development of implementing measures and 16 Details on the FSA s integrated approach to stress testing can be found in Annex Principles for sound stress testing practices and supervision Basel Committee on Banking Supervision, May Risk Management Lessons from the Global Banking Crisis of 2008 Senior Supervisors Group, October 2008 Annex 3 1

56 guidance for the Supervisory Review Process and ORSA under Solvency 2 as far as stress testing is covered. The International Association of Insurance Supervisors (IAIS) has also been developing its guidance on stress testing for insurers in light of the financial crisis. The key messages for firms described in this annex are summarised below. 1. 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. 2. 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. 3. Senior management should take action as a result of stress testing and integrate stress testing outputs into the firm s decision-making process. 4. Firms should establish a stress testing programme covering all relevant levels of its business, all risk types and over a range of severities. 5. 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. 6. 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. 7. 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. 4 The contents of this annex do not create new requirements for firms, outline specific behaviours needed to comply with our rules, nor create presumptions of breaches of our rules if not complied with. However, firms whose practice departs from that described here should be able to demonstrate how they have otherwise complied with our rules. This annex illustrates ways firms can comply with our rules and reiterates our key messages on good practice relating to stress and scenario testing, which we expect firms to have embedded in their organisations. 1. 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. 5 In order to ensure that stress and scenario testing is truly embedded in a firm s overall governance and risk management culture, board and senior management should actively engage in and drive the stress testing process within a firm, as it does with the firm s business strategy. Senior management should take ultimate responsibility, ownership and accountability for establishing the firm s stress testing programme. Without senior management engagement, our policy objectives in relation to stress and scenario testing cannot be achieved. 2 Annex 3

57 6 Firms may find it effective to delegate day-to-day accountability to an individual within the senior management of the firm such as the Chief Risk Officer or equivalent, while retaining overall responsibility for the programme. Involvement by board-level risk committees should also be considered. 2. 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. 7 In order for a firm s stress testing programme to operate effectively, senior management should be actively involved throughout the stress testing process, as highlighted at various points in this annex. For example, we believe that firms should devote sufficient time and resource to developing stress scenarios which is a collaborative process involving senior management, risk management staff and business unit staff. Views from economists may also be helpful, particularly when specifying key parameters used in macroeconomic scenarios. Firms should also give due attention to translating the scenarios designed effectively into specific effects on risk parameters. Senior management involvement in scenario selection is particularly important in firm-wide forward-looking stress testing, that requires judgement between individuals and, most crucially, senior management. 8 However, it is important to ensure that the extent of engagement by the firm s board should be determined by the scope and purpose of the stress testing activity being discussed. For example, it may appropriate for the board to engage actively in firm-wide macro-level stress testing processes but limit their involvement in more granular, portfolio-specific exercises. 9 As outlined in CP08/24, before the recent market turmoil, we observed the challenges faced by risk managers in obtaining senior management buy-in to more severe and innovative scenarios. We have since observed a change in approach by senior management where they are now more willing to explore severe and challenging scenarios. We welcome this development and wish to emphasise to senior management the importance that they continue to actively engage in the scenario definition process, particularly around assessment of severity and the mapping of scenarios to individual risk drivers. See page 25 for our latest guidance on appropriate severity. 3. Senior management should take action as a result of stress testing and integrate stress testing outputs into the firm s decision-making process. 10 Stress testing should be actionable and used to support a range of decisions within a firm s business. As the main users of stress testing output, it is ultimately the responsibility of senior management to ensure that it is integrated into the firm s decision-making. 11 Firms should use stress testing output to support decisions in at least the following areas: setting of the firm s risk appetite/tolerance; setting exposure limits; capital and liquidity planning; longer term business planning and strategic decision-making; Annex 3 3

58 assessing the consistency of risk appetite, business strategy and capital planning; risk mitigation strategies; and contingency planning. 12 For example, where stress testing outcomes are likely to be outside of the firm s risk tolerance, senior management may decide to respond by changing its strategy or shifting its business concentrations. 13 In order to make such assessments firms should undertake stress testing at all levels of the organisation covering group, division and individual business unit levels, so that the outputs produced are useful to support decision-making at the firm-wide level as well as at more granular levels. 14 Therefore it is critical that senior management are involved in the review, analysis and challenge process of the stress testing output and take an active role in defining credible and feasible mitigating management actions against this output. We expect senior management intervention to be proportionate, taking account of the degree of impact of the stress test on the firm s condition from both a business and capital adequacy perspective. 4. Firms should establish a stress testing programme covering all relevant levels of its business, all risk types and over a range of severities. 15 Firms should establish stress testing programmes that cover a wide scope of stress testing including at specific risk, portfolio, business unit and firm-wide levels. It should also cover individual and multi-risk types. 16 The programme should encourage risk identification and serve as a complementary and independent risk perspective for other risk management tools (e.g. VaR modelling), improve capital and liquidity management and improve communication within and outside the firm. 17 It is important that the programme be designed with input from various parties within an organisation so that the overall programme reflects a range of perspectives including sensitivity analysis, scenario analysis and stress testing on an individual portfolio basis as well as on a firm-wide basis. 18 Our expectations about firms stress testing are based around a principle of proportionality.for example for smaller simpler firms, stress testing may primarily be an exercise in senior management judgement on a qualitative basis. It does not necessarily involve detailed modelling. However for larger more complex firms, we would expect a more structured and comprehensive approach to stress testing, incorporating all elements covered in this annex in a sophisticated way and taking a more quantitative approach to risk identification. 5. 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. 4 Annex 3

59 19 Firms have, at times, viewed scenario selection as a backward-looking exercise. The recent financial crisis has demonstrated the flaws in placing excessive reliance on historical data and experience. Our suggestion to firms is that they should adopt a balanced approach in scenario selection, taking into account historical data and experience, but focus their thinking on forward-looking hypothetical scenarios that cover issues and risks that may not be identified by looking solely at the past and considering how relationships between risk types may behave in future stresses. 20 We require firms to undertake a range of stress testing at various levels of granularity in their business. It can be valuable for firms to take output from individual business line stress testing and aggregate this to get a detailed firm-wide picture. However, in particular for larger more complex firms, the aggregation of individual business line stress testing results should be treated with a degree of caution. Correlations, offsetting of individual exposures and risk concentrations may not be adequately captured by simple aggregation and there may either be double-counting of risks or underestimation of the impact of a stress scenario. 21 Firm-wide stress testing should be used to identify firm-wide risk concentrations that may exist both on and off-balance sheet and should also serve to highlight interdependencies and correlations of risks in stressed situations. 22 Therefore, consideration of feedback and second-order effects is important, particularly when analysing the system-wide effects of macroeconomic shocks. Although challenging to model, feedback and second-order effects should be considered, at least in a qualitative sense, for mitigating management actions to be credible and feasible. 6. 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. 23 Firms should employ IT systems, resources and procedures that would assist them in producing valuable and timely stress testing information in a useable format covering a range of metrics to senior management and other users. This principle should apply to both routine and ad hoc stress testing. High level information on the scope and outcome of the firm s stress testing programme should be provided in board risk committee or board risk reports that may be included within annual reports and accounts. 19 The report should include the nature of the stresses used, the most significant stresses and how the significance has changed during the reporting period. 24 Risk management systems should be flexible, facilitating robust, complete and accurate data gathering across the organisation at firm-wide and more granular levels so that firms have the option to undertake stress testing at varying levels of aggregation on a targeted or ad hoc basis. It is essential that underlying data produced for stress testing purposes is good quality as it is a very important input into the process and may determine how effective a firm s stress testing is. In firms where inputs from multiple IT systems are in place for stress testing, firms should put in place a robust interface between those systems, which may involve solutions from external vendors or other parties. 19 As outlined in Recommendation 27 of A review of corporate governance in UK banks and other financial industry entities (2009) by Sir David Walker. Annex 3 5

60 25 Senior management should periodically review the effectiveness of the firm s stress testing infrastructure and should ensure that necessary steps are taken for its ongoing improvement. 7. 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. 26 Firms should develop documented policies and procedures for stress testing that are approved by senior management of the firms. 27 These policies and procedures should include the following elements: the types of stress testing that the firm will undertake (including those needed to meet regulatory requirements) and the objectives behind them; indications of the frequency at which stress testing will be undertaken which will vary depending on the type and purpose of the stress testing. For example, it is likely that stress testing of individual risks will be undertaken on a relatively frequent basis in contrast to firm-wide stress testing that is likely to be done less frequently; methodologies behind scenario selection including the role of judgement in this process; records of any assumptions adopted in relation to scenario design, the firm s businesses, data quality and management actions; and provisions for management oversight, review and challenge of the stress testing process. 28 Firms should note however that documenting policies and procedures does not prevent the firm from undertaking flexible ad hoc stress testing that may be required in response to emerging risk issues. 29 Senior management should regularly review the policies and procedures in place in light of changes to individual businesses and general economic conditions. They should also include an evaluation of the overall effectiveness of the stress testing programme in meeting its objectives, including how well elements of the programme are documented. Assistance from internal audit or other independent control functions may be helpful here. 30 We have created a summary table for firms in relation to the stress testing good practices outlined in this annex and wider Policy Statement. This table may be used by firms as a list of specific things they should consider and do as part of their stress and scenario testing processes. 6 Annex 3

61 Item 1. Have the Board of Directors and senior management of the firm taken ultimate responsibility for establishing an effective stress testing programme and infrastructure at the firm? Do the board and senior management foster a culture within the firm that promotes stress testing as an important risk management tool? Has the board and senior management taken ultimate responsibility for establishing the firm s stress testing programme and supporting infrastructure including provision of sufficient resource and investment? Are clear accountabilities and responsibilities for stress and scenario testing assigned to individuals and/or groups within the firm? 2. Are senior management of the firm actively involved and sufficiently engaged in implementation of the stress testing programme? Do senior management maintain a degree of involvement and engagement at all stages of the firm s stress testing process, taking into account the scope and purpose of the stress testing activity being discussed? Have review and challenge sessions for senior management and others been established to analyse stress testing output and agree credible mitigating management actions? Firms may consider using risk assessments undertaken by business unit staff as a check and balance for the stress testing output. Is scenario selection and design a collaborative process in the firm involving representation from senior management, business unit staff, risk management staff and economists that meet on a regular basis to select and design scenarios? Are assumptions made and decisions taken regarding scenario selection in these meetings accurately documented and retained within the firm? Have the scenarios designed and selected been translated effectively into specific effects on risk parameters and is there a clear process and understanding of how this should be done? 3. Are stress testing outcomes integrated into firm decision-making through senior management, business unit and risk management staff involvement? Are the results and information from stress testing presented to senior management and other users regularly in a useful format covering a range of metrics? Are stress testing results discussed at relevant forums within the firm that include representation from appropriate staff including senior management as relevant? 4. Does the firm have a stress testing programme covering all relevant levels of its business, all risk types and over a range of severities? Are appropriate stress tests carried out on material risk types and at relevant business levels on a stand-alone basis as well as under the firm-wide stress? Are stress tests undertaken over a range of severities including one appropriately severe scenario for capital Pillar 2 purposes? Does the firm take a proportionate approach to stress testing, taking account of the nature and complexity of the business and the risks that it faces? Annex 3 7

62 Item 5. Is the firm s stress and scenario testing undertaken on a forward-looking basis, with sufficient use of firm-wide stress testing to help identify risk concentrations, assess interdependencies and understand second-order effects? Is there a specific discussion of risk concentrations in firm-wide stress test results? What assumptions does the firm make in relation to second-order effects and what analysis is used to support these assumptions? Is the firm able to identify and make use of complementarities between the different stress tests undertaken? Is the stress testing programme structured to enable senior management to take a comprehensive view of the firm s risks? Where relevant, has aggregation of stress testing outputs within the firm been approached with caution, considering offsetting exposures and correlations of risks? 6. Is there a stress testing infrastructure in place with appropriate IT systems and resources to carry out effective stress testing? Is the infrastructure periodically reviewed by senior management for its ongoing effectiveness? Are IT and risk management systems producing accurate data across the firm in a useable format for stress testing purposes? Is the firm able to present stress testing output in a useable, accessible format to circulate to senior management and other relevant staff? 7. Are clearly documented policies and procedures in place to enable effective implementation and maintenance of the stress testing programme? Are these policies and procedures periodically reviewed by senior management? 8 Annex 3

63 Annex 4 Additional guidance to insurers on the Pillar 2 capital planning stress test 1 As proposed in CP08/24, we are requiring insurers, or where applicable insurance groups, to produce a capital plan showing how they will maintain an adequate capital position, comprising eligible capital resources, in both base case and stressed scenarios. This capital plan should be based on three to five year forward projections of the firm s capital position (including the ICAS as well as the Pillar 1 CRR), with appropriate assumptions about the level of new business, if any, that is to be written. 2 We propose that the capital plan should normally be prepared or updated annually (GENPRU G), and that a copy of this plan should be sent to us, along with the insurer s ICAS, in accordance with the timetable agreed by the insurer and us. 3 The scenarios considered in these projections should be based on the guidance in our Handbook. For life insurers, the projections are intended to take account of the changes that would be intended to be made to bonus rates and surrender values in these scenarios. Insurers should identify and quantify the effect of other future offsetting management actions on which reliance is placed. They should be able to provide robust justification as to why it is reasonable to assume these actions would realistically be achievable in the stress scenario, and the timeframe in which it is envisaged that they could be executed. 4 For insurers that are members of groups, the stress tests should include those group risks that may exist over and above the risks in individual entities, as well as an assessment of the potential impact on group capital resources of possible losses in non-regulated subsidiaries. 5 In assessing the impact of a stress scenario on the adequacy of group financial resources, groups should also consider the distribution and transferability of capital within the group after stress. In particular, groups should take into account possible constraints in the stress scenario that might cause the surplus capital held in subsidiaries not to be as interchangeable as might have previously been assumed. Groups should also consider the possibility that individual subsidiaries within the group may require an injection of capital in the stress scenario, and take account of this risk in their cashflow projections. Capital injections into subsidiaries could be necessary even if group-level capital resources were still satisfactory (e.g. due to a breach by a subsidiary of local regulatory requirements, or a shortfall in Pillar 2 Annex 4 1

64 capital for UK insurance firms) or even if local subsidiaries still meet local regulatory capital requirements (e.g. if subsidiaries need to maintain particular credit ratings for business purposes). 6 In addition, we would expect insurance groups to consider the cashflow implications of these different capital projections, including under stressed conditions. In particular, groups should assess whether they will still be able to generate sufficient available cashflows in the stress scenario (e.g. from surpluses released from long-term funds, dividends from other subsidiaries, etc.) to cover any payments of interest or capital on loans, to finance new business, and to meet any other anticipated group liabilities as they fall due. 7 Insurers and relevant insurance groups should ensure that capital and group cashflow projections (before and after stress), and the management actions for which they are taking credit in their forecasts, are approved at board level. They should also consider whether any of the actions identified should be taken in advance as precautionary measures, or whether they would be relevant/desirable only in the stress scenario. 8 As well as forming a key part of firms and groups own capital planning processes, we would also expect stress testing to highlight risks for discussion between the insurance firm/group and its supervisor about risk management, and about the nature and timing of any additional steps that might need to be taken in light of the conclusions (e.g. raising capital, de-risking the business, intra-group movements of resources and other transactions, limiting new business, cutting intra-group or external dividends, or group restructuring). That discussion should also cover the adequacy of the firm s own capital buffer, and of the firm/group s capital plans. 9 In addition to the forward-looking stress testing approach described here, from time to time we may request that insurance firms and groups test the impact of a recommended scenario on their capital position. For further detail, see the box on supervisory recommended scenarios on page Annex 4

65 Annex 5 List of regulatory documents relating to stress testing Below is a list of published regulatory documents from various authorities that relate to stress testing. This list is not intended to be exhaustive. FSA 1. FS09/3: A regulatory response to the global banking crisis Feedback on DP09/2 2. FSA statement on its use stress tests May The Turner Review 4. CP08/24: Stress and scenario testing 5. Financial Risk Outlook FSA Statement on regulatory approach to bank capital January FSA Statement on Capital Approach Utilised in UK Bank Recapitalisation Package November Insurance Sector Briefing: Risk and capital management update September The FSA s internal audit review of its supervision of Northern Rock Recommendations and Actions March Stress testing thematic review October DP05/2: Stress testing May 2005 International supervisors 1. Principles for sound stress testing practices and Supervision Basel Committee on Banking Supervision May Observations on Risk Management Practices during the Recent Market Turbulence Senior Supervisors Group March The Application of the Supervisory Review Process under Pillar 2 CEBS Guidelines January 2006 Annex 5 1

66 Industry reports 1. Why Banks failed the Stress Test Bank of England February Containing Systemic Risk: The Road to Reform The Report of the CRMPG III August Final Report of the IIF Committee on Market Best Practices: Principles of Conduct and Best Practice Recommendations Institute of International Finance July Annex 5

67 Annex 6 Our approach to stress testing 1 This annex sets out our overall approach to stress and scenario testing. The annex is not intended to be a detailed or exhaustive list of all of our stress testing components. However, we believe it is important to communicate our current approach and the ongoing work we are undertaking on stress testing so that firms and other interested parties are aware of developments. 2 Our integrated approach to stress testing consists of: Firms own stress testing. We expect firms to improve their stress testing and develop, implement and action a robust and effective stress testing programme which assesses their ability to meet capital and liquidity requirements in stressed conditions, as a key component of effective risk management. Supervisory stress testing of specific high impact firms. We run our own stress tests on a regular basis for particular firms to assess their ability to meet minimum specified capital levels and other regulatory requirements throughout a stressed period. Simultaneous system-wide stress testing undertaken by firms using a common scenario for financial stability purposes. 3 These three elements are interlinked and mutually reinforcing. The diagram below illustrates our integrated approach to stress testing as described above. It also highlights the links between firms own stress testing, supervisory stress testing, and micro-prudential analysis, all of which focus on the capital or liquidity outcomes of individual firms. Equally, it highlights links between system-wide stress testing and macro-prudential analysis as these stress tests focus on gauging system-wide impacts of stress events. 4 To support the three broad elements of our framework, the following activities are required: policy setting of firms stress testing requirements; setting stress scenarios (supervisory recommended scenarios or system-wide scenarios); and monitoring and aggregating stress test scenarios and results. Annex 6 1

68 Interlinked analysis Micro-prudential analysis Macro-prudential analysis Setting stress testing policy Firms own stress testing Capital Supervisory stress testing FSA stress testing of specific firms System-wide stress testing Simultaneous stress testing Setting scenarios Monitoring and aggregation Liquidity Reverse stresstesting Assessment against minimum specified capital and liquidity requirements Financial stability purposes FSA Objectives Firms own stress testing 5 We require firms to undertake a wide range of stress tests that contribute to the comprehensive suite of risk management processes, strategies and systems that we require firms to embed into their organisations as appropriate to the nature, scale and complexity of the risks that they bear as part of effective risk management. ICAAP/ICAS Reverse stress-testing System-wide stress testing Other Pillar 1 Sensitivity analysis and scenario analysis on specific risk-types Banks, building societies, insurers and investment firms Stress testing of firms business model vulnerabilities All banks, building societies, insurers and some investment firms FSA macroeconomic or financial shock scenarios to assess system-wide impacts. Firm s own stress testing programme Banks, building societies, insurers and investment firms Pillar 2 Firm-wide stress testing International system-wide stress testing initiatives Other mandated stress tests Non-UK supervisors Likely to be macroeconomic scenarios either developed by firms or supervisory recommended scenarios Other regulatory authorities Banks, building societies, insurers and investment firms 2 Annex 6

69 ICAAP/ICAS Reverse stress-testing System-wide stress testing Liquidity Stress tests for Individual Liquidity Adequacy Assessments All BIPRU firms with a carve out for some investment firms Other Supervisory stress testing Supervisory stress testing 6 We recognise that our stress testing requirements are comprehensive and have grown in recent years. We note that a robust stress testing infrastructure in a firm (see Annex 3 for further details) will facilitate the effective implementation of a wide range of stress testing. We also note that the stress testing requirements above are generally complementary building blocks. However, we also recognise our role in ensuring that the way in which we set these requirements should be designed to minimise any potential burden and avoid duplication. Supervisory recommended scenarios 7 As explained in this Policy Statement on page 28, we intend to introduce supervisory recommended scenarios for firms to run from time to time. We continue to believe that ultimate responsibility for scenario selection rests with firms senior management but our experience during the current crisis has been that there is value in supervisory recommended scenarios as a complement to firms own scenarios. 8 We may require individual firms to run our recommended scenario as an additional input to their ICAAP/ICAS submission. However, for more general use we will formulate a wide-ranging macroeconomic scenario which reflects relevant supervisory concerns and risk tolerance to serve as an anchor for firms to build around in the development of their own scenarios. The high level parameters of the scenario will be communicated externally. Supervisory stress testing 9 Firms will be aware that we undertake our own stress testing for some firms from time to time to conduct our own analysis of firms, in addition to analysing the results of stress testing that firms undertake themselves. Supervisory stress testing requires in-house modelling capability, such as that we now have for capital and liquidity. This does of course require more data to be collected from firms. It will also involve us looking more closely at the inherent prudential and conduct risks of a firm s business. Annex 6 3

70 10 We use our own analysis to determine the firm s capital position in a stress against minimum specified capital levels 20 e.g. 4% Core Tier 1 post-stress ratio and the individual capital guidance (ICG) we have given to the firm. Simultaneous system-wide stress testing 11 Stress testing is a particularly useful tool in macro-prudential oversight and for financial stability purposes as a means of gauging the system-wide effects of stresses and second order effects. We are continuing our work in this area to develop an exercise (separate to Pillar 2 firm stress testing and supervisory stress testing) which would involve a peer group of firms simultaneously testing against a common stress scenario. 12 The scenario designed for this simultaneous stress test may at times differ from our supervisory recommended scenario, to reflect the different objectives of the tests, the former being to observe system-wide impacts of a scenario rather than firm-specific impacts. Monitoring and reporting 13 We recognise that under our strengthened stress testing regime, we will see significant amounts of information about individual firms and the financial system as a whole. We are committed to using this information in the best way possible to improve the quality of our work. In this context we are working to develop an effective framework to facilitate coordination and monitoring of the various strands of stress testing, including outputs and scenarios being used. 20 For banks this includes all relevant capital ratios in the in the supervisory framework including individual capital guidance (ICG) and other relevant ratios: Annex 6

71 Annex 7 List of acronyms ARROW CBA CEIOPS CP CPB CRD FSA Advanced risk responsive operating framework Cost-benefit analysis Committee of European Insurance & Occupational Pensions Supervisors Consultation Paper Capital planning buffer Capital Requirements Directive Financial Services Authority FSMA Financial Services & Markets Act (2000) ICAS ICAAP ICG MFA ORSA PS SREP Individual capital assessment Internal capital adequacy assessment process Individual capital guidance Market-failure analysis Own Risk and Solvency Assessment Policy Statement Supervisory review and evaluation process Annex 7 1

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73 Appendix 1 Final Handbook text

74 FSA 2009/72 PRUDENTIAL REQUIREMENTS (STRESS TESTING) INSTRUMENT 2009 Powers exercised A. The Financial Services Authority makes this instrument in the exercise of: (1) the following powers and related provisions in the Financial Services and Markets Act 2000 ( the Act ): (a) (b) (c) (d) section 138 (General rule-making power); section 150(2) (Actions for damages); section 156 (General supplementary powers); and section 157(1) (Guidance); and (2) the other powers and related provisions listed in Schedule 4 (Powers exercised) to the General Provisions of the Handbook. B. The rule-making powers referred to above are specified for the purpose of section 153(2) (Rule-making instruments) of the Act. Commencement C. (1) Part 1 of Annexes A, B and C and Annexes D and E come into force on 14 December (2) Part 2 of Annexes A, B and C come into force on 14 December Amendments to the Handbook D. The modules of the FSA s Handbook of rules and guidance listed in column (1) below are amended in accordance with the Annexes to this instrument listed in column (2). Citation (1) (2) Glossary of definitions Annex A Senior Management Arrangements, Systems and Controls sourcebook Annex B (SYSC) General Prudential sourcebook (GENPRU) Annex C Prudential sourcebook for Banks, Building Societies and Investment Annex D Firms (BIPRU) Prudential sourcebook for Insurers (INSPRU) Annex E E. This instrument may be cited as the Prudential Requirements (Stress Testing) Instrument By order of the Board 10 December 2009

75 FSA 2009/72 In this Annex, underlining indicates new text. Annex A Amendments to the Glossary of definitions Part 1: Comes into force on 14 December 2009 group (3) (for the purposes of SYSC 12 (Group risk systems and controls requirement) and GENPRU 1.2 (Adequacy of financial resources) and in relation to a person A )) A and any person: (a) who falls into (1); (b) (c) (d) (e) (f) who is a member of the same financial conglomerate as A; who has a consolidation Article 12(1) relationship with A; who has a consolidation Article 12(1) relationship with any person in (3)(a); who is a subsidiary undertaking of a person in (3)(c) or (3)(d); or whose omission from an assessment of the risks to A of A s connection to any person coming within (3)(a)-(3)(e) or an assessment of the financial resources available to such persons would be misleading. Page 2 of 26

76 FSA 2009/72 Part 2: Comes into force on 14 December 2010 group (3) (for the purposes of SYSC 12 (Group risk systems and controls requirement), SYSC 20 (Reverse stress testing) and GENPRU 1.2 (Adequacy of financial resources) and in relation to a person A )) A and any person: (a) who falls into (1); (b) (c) (d) (e) (f) who is a member of the same financial conglomerate as A; who has a consolidation Article 12(1) relationship with A; who has a consolidation Article 12(1) relationship with any person in (3)(a); who is a subsidiary undertaking of a person in (3)(c) or (3)(d); or whose omission from an assessment of the risks to A of A s connection to any person coming within (3)(a)-(3)(e) or an assessment of the financial resources available to such persons would be misleading. Page 3 of 26

77 FSA 2009/72 Annex B Amendments to the Senior Management Arrangements, Systems and Controls sourcebook (SYSC) In this Annex, underlining indicates new text and striking through indicates deleted text, unless otherwise stated. Part 1: Comes into force on 14 December G For the purposes of SYSC R, the question of whether the risk management processes and internal control mechanisms are adequate, sound and appropriate should be judged in the light of the nature, scale and complexity of the group s business and of the risks that the group bears. Risk management processes must include the stress testing and scenario analysis required by GENPRU R and GENPRU R(1)(b). Part 2: Comes into force on 14 December A G Other firms should take account of the risk management rules (SYSC 7.1.3R and SYSC 7.1.4R) as if they were guidance (and as if "should" appeared in those rules instead of "must") as explained in SYSC 1 Annex 1.3.3G. For a common platform firm included within the scope of SYSC 20 (Reverse stress testing), the strategies, policies and procedures for identifying, taking up, managing, monitoring and mitigating the risks to which the firm is or might be exposed include conducting reverse stress testing in accordance with SYSC 20. A common platform firm which falls outside the scope of SYSC 20 should consider conducting reverse stress tests on its business plan as well. This would further senior personnel s understanding of the firm s vulnerabilities and would help them design measures to prevent or mitigate the risk of business failure B G Other firms should take account of the risk management rules (SYSC 7.1.3R and SYSC 7.1.4R) as if they were guidance (and as if "should" appeared in those rules instead of "must") as explained in SYSC 1 Annex 1.3.3G. After SYSC 19, insert the following new chapter. The text is not underlined. 20 Reverse stress testing 20.1 Application and purpose Application R (1) SYSC 20 applies to: Page 4 of 26

78 FSA 2009/72 (a) (b) a BIPRU firm, unless it is a BIPRU investment firm excluded in accordance with (2); and an insurer unless it is: (i) (ii) (iii) (iv) (v) a non-directive friendly society; or a Swiss general insurer; or an EEA-deposit insurer; or an incoming EEA firm; or an incoming Treaty firm. (2) Subject to (3) and (4), a BIPRU investment firm is excluded from the scope of SYSC 20 if: (a) (b) (c) where it carries out the regulated activity of managing investments or safeguarding and administering investments, it has assets under management or administration of no more than 10 billion (or the equivalent amount in foreign currency); or the total annual fee and commission income arising from its regulated activities is no more than 250 million (or the equivalent amount in foreign currency); or it has assets and liabilities of no more than 2 billion (or the equivalent amount in foreign currency). Purpose (3) In order to determine whether a BIPRU investment firm is excluded from the scope of SYSC 20, the exclusion criteria in (2) apply on a consolidated basis to all of the BIPRU investment firms within the same UK consolidation group or non-eea sub-group as if they were one firm. (4) Any BIPRU investment firm which is not excluded in accordance with (2) and (3) in any given year will continue to be subject to SYSC 20 for the following two years irrespective of whether it satisfies the criteria to be excluded in any of those subsequent years G This chapter amplifies Principle 2, under which a firm must conduct its business with due skill, care and diligence, and Principle 3, under which a firm must take reasonable care to organise and control its affairs responsibly and effectively, with adequate risk management systems. Page 5 of 26

79 FSA 2009/ G This chapter contains 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 G The reverse stress testing requirements are an integral component of a firm s business planning and risk management under SYSC. For BIPRU firms as referred to in SYSC R(1)(a), this chapter amplifies SYSC 7.1.1G to SYSC 7.1.8G on risk control. For insurers as referred to in SYSC R(1)(b), this chapter amplifies SYSC G to SYSC G on business planning and risk management Reverse stress testing requirements R As part of its business planning and risk management obligations under SYSC, a firm must reverse stress test its business plan; that is, it must carry out stress tests and scenario analyses that test its business plan to failure. To that end, the firm must: (1) identify a range of adverse circumstances which would cause its business plan to become unviable and assess the likelihood that such events could crystallise; and (2) where those tests reveal a risk of business failure that is unacceptably high when considered against the firm s risk appetite or tolerance, adopt effective arrangements, processes, systems or other measures to prevent or mitigate that risk R Where the firm is a member of: (1) an insurance group, in respect of which it is required to maintain group capital; (2) a UK consolidation group; or (3) a non-eea sub-group; it must conduct the reverse stress test on a solo basis as well as on a consolidated basis in relation to the insurance group, the UK consolidation group or the non-eea sub-group, as the case may be. Page 6 of 26

80 FSA 2009/ R The design and results of a firm s reverse stress test must be documented and reviewed and approved at least annually by the firm s senior management or governing body. A firm must update its reverse stress test more frequently if it is appropriate to do so in the light of substantial changes in the market or in macroeconomic conditions G (1) Business plan failure in the context of reverse stress testing should be understood as the point at which the market loses confidence in a firm and this results in the firm no longer being able to carry out its business activities. Examples of this would be the point at which all or a substantial portion of the firm s counterparties are unwilling to continue transacting with it or seek to terminate their contracts, or the point at which the firm s existing shareholders are unwilling to provide new capital. Such a point may be reached well before the firm s financial resources are exhausted. (2) The FSA may request a firm to quantify the level of financial resources which, in the firm s view, would place it in a situation of business failure should the identified adverse circumstances crystallise. (3) In carrying out the stress tests and scenario analyses required by SYSC R, a firm should at least take into account each of the sources of risk identified in accordance with GENPRU R(2) G Reverse stress testing should be appropriate to the nature, size and complexity of the firm s business and of the risks it bears. Where reverse stress testing reveals that a firm s risk of business failure is unacceptably high, the firm should devise realistic measures to prevent or mitigate the risk of business failure, taking into account the time that the firm would have to react to these events and implement those measures. As part of these measures, a firm should consider if changes to its business plan are appropriate. These measures, including any changes to the firm s business plan, should be documented as part of the results referred to in SYSC R G In carrying out its reverse stress testing, a firm should consider scenarios in which the failure of one or more of its major counterparties or a significant market disruption arising from the failure of a major market participant, whether or not combined, would cause the firm s business to fail G (1) The FSA may request a firm to submit the design and results of its reverse stress tests and any subsequent updates as part of its ARROW risk assessment. (2) In the light of the results of a firm s reverse stress tests, the FSA may require the firm to implement specific measures to prevent or mitigate the risk of business failure where that risk is not sufficiently mitigated by the measures adopted by the firm in accordance with SYSC R, and the firm s potential failure poses an unacceptable risk to the FSA s statutory objectives. Page 7 of 26

81 FSA 2009/72 (3) The FSA recognises that not every business failure is driven by lack of financial resources and will take this into account when reviewing a firm s reverse stress test design and results. Page 8 of 26

82 FSA 2009/72 Annex C Amendments to the General Prudential sourcebook (GENPRU) In this Annex, underlining indicates new text and striking through indicates deleted text. Part 1: Comes into force on 14 December G The liabilities referred to in the overall financial adequacy rule include a firm s contingent and prospective liabilities. It excludes They exclude liabilities that might arise from transactions that a firm has not entered into and which it could avoid, for example, by ceasing to trade taking realistic management actions such as ceasing to transact new business after a suitable period of time has elapsed. It includes They include liabilities or costs that arise as a consequence of strategies other than continuing as both in scenarios where the firm is a going concern and those where the firm ceases to be a going concern. It They also includes include claims that could be made against a firm, which ought to be paid in accordance with fair treatment of customers, even if such claims could not be legally enforced. Systems, strategies, processes and reviews R A firm must have in place sound, effective and complete processes, strategies and systems: (2) that enable it to identify and manage the major sources of risks referred to in (1), including the major sources of risk in each of the following categories where they are relevant to the firm given the nature and scale of its business: (j) (k) (l) interest rate risk (including in the case of a BIPRU firm, interest rate risk in the non-trading book); and pension obligation risk; and group risk G (1) This paragraph gives guidance on some of the terms used in the overall Pillar 2 rule. Page 9 of 26

83 FSA 2009/72 (6) Group risk is the risk that the financial position of a firm may be adversely affected by its relationships (financial or non-financial) with other entities in the same group or by risks which may affect the financial position of the whole group, for example reputational contagion. Further guidance on group risk can be found in GENPRU G to GENPRU G R The processes and systems required by the overall Pillar 2 rule must: (1) include an assessment of how it the firm intends to deal with each of the major sources of risk identified in accordance with GENPRU R(2); and (2) take into account the impact of diversification effects and how such effects are factored into the firm s systems for measuring and managing risks; and (3) include an assessment of the firm-wide impact of the risks identified in accordance with GENPRU R(2), to which end a firm must aggregate the risks across its various business lines and units, making appropriate allowance for the correlation between risks. Stress and scenario tests R (1) As part of its obligation under the overall Pillar 2 rule, a firm must, for each of the major sources of risk identified in accordance with GENPRU R(2), carry out stress tests and scenario analyses that are appropriate to the nature, scale and complexity of those major sources of risk and to the nature, scale and complexity of the firm s business, as part of which the firm must: (a) (b) take reasonable steps to identify an appropriate range of realistic adverse circumstances and events in which the risk identified crystallises; and estimate the financial resources the firm would need in each of the circumstances and events considered in order: (i) (ii) (iii) (iv) to be able to meet its liabilities as they fall due; to be able to meet the CRR; to carry out the plans referred to in GENPRU R (1); and otherwise to meet, to the extent that it considers necessary, that major source of risk. Page 10 of 26

84 FSA 2009/72 (2) In carrying out the stress tests and scenario analyses in (1), a BIPRU firm with an IRB permission must incorporate and take into account the stress tests required to be carried out under BIPRU R to BIPRU R (Stress tests used in assessment of capital adequacy) identify an appropriate range of adverse circumstances of varying nature, severity and duration relevant to its business and risk profile and consider the exposure of the firm to those circumstances, including: (a) (b) (c) circumstances and events occurring over a protracted period of time; sudden and severe events, such as market shocks or other similar events; and some combination of the circumstances and events described in (a) and (b), which may include a sudden and severe market event followed by an economic recession. (3) In carrying out the stress tests and scenario analyses in (1), a BIPRU firm must incorporate and take into account any other stress tests and scenario analyses that it is required to carry out under any other provision of the Handbook. In carrying out the stress tests and scenario analyses in (1), the firm must estimate the financial resources that it would need in order to continue to meet the overall financial adequacy rule and the CRR in the adverse circumstances being considered. (4) In carrying out the stress tests and scenario analyses in (1), the firm must assess how risks aggregate across business lines or units, any material non-linear or contingent risks and how risk correlations may increase in stressed conditions. (5) As part of its obligation under the overall Pillar 2 rule, a BIPRU firm must also incorporate and take into account any stress tests and scenario analyses that it is required to carry out under BIPRU. In particular, a BIPRU firm with an IRB permission must incorporate and take into account the stress test required to be carried out under BIPRU R(2) A G In order to comply with the general stress and scenario testing rule, a firm should undertake a broad range of stress tests which reflect a variety of perspectives, including sensitivity analysis, scenario analysis and stress testing on an individual portfolio as well as a firm-wide level B G A BIPRU firm with an IRB permission which has any material credit exposures excluded from its IRB models should also include these exposures in its stress and scenario testing to meet its obligations under the general stress and scenario testing rule. A BIPRU firm without an IRB permission, or an insurer that has any material credit and counterparty credit risk exposures, should conduct analyses to assess risks to the credit quality of its Page 11 of 26

85 FSA 2009/72 counterparties, including any protection sellers, considering both on and offbalance sheet exposures C G An insurer may choose to carry out its ICA through the use of stress testing and scenario analyses (see INSPRU G and INSPRU G). If it does so, in carrying out the stress tests and scenario analyses referred to in GENPRU R, an insurer should take into account the stress tests it uses for its ICA D G In carrying out the stress tests and scenario analyses required by GENPRU R(1), a firm should also consider any impact of the adverse circumstances on its capital resources. In particular, a firm should consider the capital resources gearing rules where its tier one capital is eroded by the event E G A firm should assign adequate resources, including IT systems, to stress testing and scenario analysis, taking into account the stress testing techniques employed, so as to be able to accommodate different and changing stress tests at an appropriate level of granularity F G GENPRU G to GENPRU G provide additional guidance on stress testing and scenario analyses. In particular, GENPRU AG provides specific guidance on capital planning. Documentation of risk assessments R A firm must make a written record of the assessments required under this section. These assessments include assessments carried out on a consolidated basis and on a solo basis. In particular, it must make a written record of: (3) details of the stress tests and scenario analyses carried out, including any assumptions made in relation to scenario design, and the resulting financial resources estimated to be required in accordance with the general stress and scenario testing rule. Page 12 of 26

86 FSA 2009/72 Additional guidance on stress tests and scenario analyses G The general stress and scenario testing rule requires a firm to carry out stress tests and scenario analyses as part of its obligations under the overall Pillar 2 rule. Both stress tests and scenario analyses can be are undertaken by a firm to further a better understanding of the vulnerabilities that it faces under extreme adverse conditions. They are based on the analysis of the impact of unlikely, but not impossible, events a range of events of varying nature, severity and duration. These events can be financial, operational or legal or relate to any other risk that might have an economic impact on the firm G The general stress and scenario testing rule requires a firm, as part of carrying out stress tests and scenario analyses, to take reasonable steps to identify an appropriate range of realistic circumstances and events in which a risk would crystallise. In particular: (1) a firm need only carry out stress tests and scenario analyses in so far as the circumstances or events are reasonably foreseeable, that is to say, their occurrence is not too remote a possibility: and (2) a firm should also take into account the relative costs and benefits of carrying out the stress tests and scenario analyses in respect the circumstances and events identified. [deleted] G Where a firm is exposed to market risk, The the time horizon over which stress tests and scenario analysis analyses should be carried out should will depend on, among other things, the maturity and liquidity of the positions stressed. For example, for the market risk arising from the holding of investments, this should will depend upon: (2) the extent to which the market in those assets is sufficiently liquid (and would remain liquid in the changed circumstances contemplated in the stress test or scenario analysis) to allow the firm, if needed, to sell, hedge or otherwise mitigate the risks relating to its holding so as to prevent or reduce exposure to future price fluctuations. In devising stress tests and scenario analyses for market risk, a BIPRU firm should also take into account BIPRU R to BIPRU G G (1) A firm should conduct stress tests and scenario analyses which project its financial position (both profitability and balance sheet Page 13 of 26

87 FSA 2009/72 position) so as to estimate both its capital resources and capital resource requirements throughout an economic or business cycle. [deleted] (1A) For an insurer, these tests and analyses are in addition to those that may be used for the ICA (see INSPRU G and INSPRU G). Projections should be made on different bases, including ones which are consistent with the business plan, as well as others using realistically adverse alternative scenarios. In considering the tests and analyses to be used for the purposes of these projections, an insurer should have regard to the matters mentioned below. (a) (b) (c) (d) As with the ICA, it is for the insurer to identify an appropriate range of adverse circumstances and events. As the projections are being assessed as part of business planning, the FSA would expect stresses and scenarios to be more likely than the extreme conditions covered by an ICA. As a guide, stresses and scenarios with a probability of once in a 25 year period would be useful as a reference when an insurer discusses projections of its financial position with the FSA (see also GENPRU G (3)). Business risk is likely to be a more significant feature in projecting an insurer s financial position than in its ICA (see GENPRU R and GENPRU G). The treatment of new business is likely to be different for projecting an insurer s financial position than in its ICA. In the former, this should be based on the firm s business plan, but flexed to incorporate potential changes in trading conditions and strategy. In the latter, account should be taken of the effects of a closure to new business (see GENPRU G, GENPRU G(3) and INSPRU G to INSPRU G). Methods that are more approximate than used for an ICA may be appropriate for projecting elements of an insurer s financial position (e.g. the with-profits insurance capital component for realistic basis life firms). [deleted] (2) A firm will need to consider the cycles it is most exposed to and whether these are general economic cycles or specific to particular markets, sectors or industries. The length of time over which such projections would be appropriate will therefore vary, but typically might be between three and five years. [deleted] (3) The projections should be based on the firm s business plan, but flexed to incorporate adverse trading conditions and any changes in strategy which the firm could and would take in response to those conditions. [deleted] Page 14 of 26

88 FSA 2009/72 (4) Changes in strategy might be necessary for instance because capital needed to be able to continue its business at existing volumes is eroded. A firm may also alter its capital management strategy to restrict distributions of profits or to raise additional capital. The combined effect on capital and retained earnings should be estimated. A firm should document how it would react to such economic and business risks. [deleted] (5) The FSA will take the projections referred to in this paragraph and the plan referred to in (4) into account as part of its SREP. The purpose of examining them is to enable the FSA to judge, at an appropriate level of certainty, whether the firm will be able to meet its obligations throughout a recession. [deleted] Capital planning A G (1) In identifying an appropriate range of adverse circumstances and events in accordance with GENPRU R(2): (a) (b) (c) (d) a firm will need to consider the cycles it is most exposed to and whether these are general economic cycles or specific to particular markets, sectors or industries; for the purposes of GENPRU R(2)(a), the amplitude and duration of the relevant cycle should include a severe downturn scenario based on forward looking hypothetical events, calibrated against the most adverse movements in individual risk drivers experienced over a long historical period; the adverse scenarios considered should in general be acyclical and, accordingly, the scenario should not become more severe during a downturn and less severe during an upturn. However, the FSA does expect scenarios to be updated with relevant new economic data on a pragmatic basis to ensure that the scenario continues to be relevant; and the adverse scenarios considered should reflect a firm s risk tolerance of the adverse conditions through which it expects to remain a going concern. (2) In making the estimate required by GENPRU R(3), a firm should project both its capital resources and its required capital resources over a time horizon of 3 to 5 years, taking account of its business plan and the impact of relevant adverse scenarios. In making the estimate, the firm should consider both the capital resources required to meet its CRR and the capital resources needed to meet the overall financial adequacy rule. The firm should make these projections in a manner consistent with its risk management processes and systems as set out in GENPRU R. Page 15 of 26

89 FSA 2009/72 (3) In projecting its financial position over the relevant time horizon, the firm should: (a) (b) (c) (d) (e) reflect how its business plan would flex in response to the adverse events being considered, taking into account factors such as changing consumer demand and changes to new business assumptions; consider the potential impact on its stress testing of dynamic feedback effects and second order effects of the major sources of risk identified in accordance with GENPRU R(2); estimate the effects on the firm s financial position of the adverse event without adjusting for management actions; separately, identify any realistic management actions that the firm could and would take to mitigate the adverse effects of the stress scenario; and estimate the effects of the stress scenario on the firm s financial position after taking account of realistic management actions. (4) A firm should identify any realistic management actions intended to maintain or restore its capital adequacy. These could include ceasing to transact new business after a suitable period has elapsed, balance sheet shrinkage, restricting distribution of profits or raising additional capital. A firm should reflect management actions in its projections only where it could and would take such actions, taking account of factors such as market conditions in the stress scenario and any effects upon the firm s reputation with its counterparties and investors. The combined effect on capital and retained earnings should be estimated. In order to assess whether prospective management actions in a stress scenario would be realistic and to determine which actions the firm would and could take, the firm should take into account any preconditions that might affect the value of management actions as risk mitigants and analyse the difference between the estimates in (3)(c) and (3)(e) in sufficient detail to understand the implications of taking different management actions at different times, particularly where they represent a significant divergence from the firm s business plan. (5) The firm should document its stress testing and scenario analysis policies and procedures, as well as the results of its tests in accordance with GENPRU R. These records should be included within the firm s ICAAP or ICA submission document. (6) The FSA will review the firm s records referred to in (5) as part of its SREP. The purpose of examining these is to enable the FSA to judge whether a firm will be able to continue to meet its CRR and Page 16 of 26

90 FSA 2009/72 the overall financial adequacy rule throughout the projection period. (7) If, after taking account of realistic management actions, a firm s stress testing management plan shows that the firm s projected capital resources are less than those required to continue to meet its CRR or less than those needed to continue to meet the overall financial adequacy rule over the projection period, the FSA may require the firm to set out additional countervailing measures and off-setting actions to reduce such difference or to restore the firm s capital adequacy after the stress event. (8) The firm s senior management or governing body should be actively involved and engaged in all relevant stages of the firm s stress testing and scenario analysis programme. This would include establishing an appropriate stress testing programme, reviewing the programme s implementation (including the design of scenarios) and challenging, approving and actioning the results of the stress tests. (9) For an insurer: (a) (b) the treatment of new business when making capital projections is likely to be different from its ICA. In projecting its financial position, an insurer should take account of new business based on the firm's business plan, but flexed to take account of potential changes in trading conditions and strategy. When assessing its current capital adequacy under its ICA, an insurer should take account of the effects of closure to new business (see GENPRU G, GENPRU AG(3) and (4) and INSPRU G to INSPRU G). Also, an insurer may use methods that are more approximate than used for its ICA (for example, in projecting the with-profits insurance capital component for realistic basis life firms and the capital resources needed to meet the overall financial adequacy rule); and where management discretion is exercised as a normal part of an insurer s business (for example, in changing bonus rates or surrender values in accordance with the PPFM for with-profits business), under (3)(c) the insurer does not need to estimate the effect of an adverse event on its financial position without adjusting for such changes. However, the effect on the financial position of varying such actions should be estimated and understood B G The FSA may formulate macroeconomic and financial market scenarios which a firm may use as an additional input to its ICAAP or ICA submission. In addition, the FSA may also ask a firm to apply specific scenarios directly in its ICAAP or ICA submission. Page 17 of 26

91 FSA 2009/ G (1) A firm should assess the nature and severity of the economic recession or business cycle changes which are relevant to it given the nature and scale of its business. When projecting its capital resources and CRR, a firm should consider a range of stresses and scenarios both in nature and severity. [deleted] (2) Stress and scenario analyses should, in the first instance, be aligned with the risk appetite of the firm, as well as the nature, scale and complexity of its business and of the risks that it bears. and the The calibration of such the stress and scenario analyses should be reconciled back to a clear statement setting out the premise upon which the firm s internal capital assessment under the overall Pillar 2 rule is based. (3) A firm with an IRB permission should ensure that the range of stresses and scenarios considered encompasses the severity of recession specified in BIPRU R (Stress tests used in assessment of capital adequacy), which is one that might be expected to occur once in a 25 year period. Other firms may also find that this is a useful reference point when discussing their assessments with the FSA. [deleted] (4) Pension obligation risk G GENPRU G to GENPRU G contain guidance on the assessment required by GENPRU R(2)(k) (Pension risk) for a firm exposed to pension obligation risk as defined in GENPRU R(5) G The pension scheme itself (i.e. the scheme s assets and liabilities) is not the focus of the risk assessment; but rather it is the firm s obligations towards the pension scheme which is. A firm should include in its estimate of financial resources both its expected obligations to the pension scheme and any increase in obligations that may arise in a stress scenario G A firm should also assess the risks that may increase its current funding obligations towards the pension scheme and that might lead to the firm not being able to pay its other liabilities as they fall due A G A firm is expected to determine where the scope of any stress test impacts upon its pension obligation risk and estimate how the relevant measure of Page 18 of 26

92 FSA 2009/72 pension obligation risk will change in the scenario in question. For example, in carrying out stress tests under GENPRU R a firm must consider how a stress scenario, such as an economic recession, would impact on the firm s current obligations towards its pension scheme and any potential increase in those obligations. Risks such as interest rate risk or reduced investment returns may have a direct impact on a firm s financial position as well as an indirect impact resulting from an increase in the firm s pension scheme obligations. Both effects should be taken into account in a firm s estimate of financial resources under GENPRU R. Group risk G GENPRU G to GENPRU G contain additional guidance on the assessment required by GENPRU R(2)(l) (Group risk) G A firm should include in the written record referred to in GENPRU R a description of the broad business strategy of the insurance group, the UK consolidation group or the non-eea sub-group of which it is a member, the group s view of its principal risks and its approach to measuring, managing and controlling the risks. This description should include the role of stress testing, scenario analysis and contingency planning in managing risk at the solo and consolidated level G A firm should satisfy itself that the systems (including IT) of the insurance group, the UK consolidation group or the non-eea sub-group of which it is a member are sufficiently sound to support the effective management and, where applicable, the quantification of the risks that could affect the insurance group, the UK consolidation group or the non-eea sub-group, as the case may be G In performing stress tests and scenario analyses, a firm should take into account the risk that its group may have to bring back on to its consolidated balance sheet the assets and liabilities of off-balance sheet entities as a result of reputational contagion, notwithstanding the appearance of legal risk transfer G A firm should carry out stress tests and scenario analyses to a degree of sophistication which is commensurate with the complexity of its group and the nature of its group risk. Page 19 of 26

93 FSA 2009/72 Part 2: Comes into force on 14 December G (1) (4) A firm may also consider scenarios in which the amount of capital it currently holds would be exhausted. This would provide useful information about the reasonableness or remoteness of such scenarios arising. Where a firm uses capital models as part of its risk management processes, considering the sensitivity of model results to variations around the most likely ruin scenario focuses testing on the most relevant scenarios. In identifying adverse circumstances and events in accordance with GENPRU R(2), a firm should consider the results of any reverse stress testing conducted in accordance with SYSC 20. Reverse stress testing may be expected to provide useful information about the firm s vulnerabilities and variations around the most likely ruin scenarios for the purpose of meeting the firm s obligations under GENPRU R. In addition, such a comparison may help a firm to assess the sensitivity of its financial position to different stress calibrations. Page 20 of 26

94 FSA 2009/72 Annex D Amendments to the Prudential sourcebook for Banks, Building Societies and Investment Firms (BIPRU) In this Annex, underlining indicates new text and striking through indicates deleted text G If the FSA gives individual capital guidance to a firm, the FSA will state what amount and quality of capital the FSA considers the firm needs to hold in order to comply with the overall financial adequacy rule. It will generally do so by saying that the firm should hold capital resources of an amount which is at least equal to a specified percentage of that firm s capital resources requirement. Such amount should be sufficient to enable the firm to continue to meet the overall financial adequacy rule in the face of the adverse circumstances and events to which GENPRU R(2) refers, taking account of any risk mitigation available to the firm G (1) This paragraph applies to a small firm whose activities are simple and primarily not credit-related. (4) A firm should conduct stress tests and scenario analyses in accordance with GENPRU R to assess how that firm s capital and CRR would alter and what that firm s reaction might be to a range of adverse scenarios, including operational and market events. Where relevant, a firm should also consider the impact of an a severe economic or industry downturn on its future earnings, capital resources and capital resources requirement, taking into account its business plans. The downturn scenario should be based on forward looking hypothetical events calibrated against the most adverse movements in individual risk drivers experienced over a long historical period G In relation to a firm whose activities are moderately complex, in carrying out its ICAAP, BIPRU G(3) to (4) apply. In addition, it could: (7) assume that business does not develop as expected and consider how that firm s capital and CRR would alter and what that firm s reaction to a range of adverse economic scenarios might be (see GENPRU R to GENPRU G (the overall Pillar 2 rule and related rules and guidance)). Where appropriate, the adverse scenarios should consider the impact of market events that are instantaneous or occur over an extended period of time but which are nevertheless still co-dependent on movements in economic conditions; Page 21 of 26

95 FSA 2009/ G To assess its expected capital requirements over the economic and business cycles, a firm may wish to project forward its financial position taking account of its business strategy and expected growth according to a range of assumptions as to the state of the economic or business environment which it faces. For example, an ICAAP should include an analysis of the impact that the actions of a firm's competitors might have on its performance, in order to see what changes in its environment the firm could sustain. Projections over a three to five year period would be appropriate in most circumstances. A firm may then calculate its projected CRR and assess whether it could be met from expected financial resources. Additional guidance on capital planning over an economic and business cycle can be found in GENPRU AG (Capital planning) G If a firm's current available capital resources are less than the capital resources requirement indicated by the stress test that need not be a breach of BIPRU R. The firm may wish to set out any countervailing effects and off-setting actions that can be demonstrated to the satisfaction of the FSA as being likely to reduce the difference referred to in the first sentence. The FSA is only likely to consider a demonstration of such actions as credible if those actions are set out in a capital management plan based on the procedures in GENPRU G (Stress tests and scenario analyses throughout an economic or business cycle) AG (Capital planning) and including a plan of the type referred to in GENPRU G(4) AG(5) that has been approved by the firm's senior management or governing body G For a larger and/or more complex firm, appropriate systems to evaluate and manage interest rate risk in the non-trading book may should include: (1) the ability to measure the exposure and sensitivity of the firm s activities, if material, to repricing risk, yield curve risk, basis risk and risks arising from embedded optionality (for example, pipeline risk, prepayment risk) as well as changes in the shape of the yield curve, changes between different market rates (i.e. basis risk) and changes to assumptions (for example, those about customer behaviour); A G The FSA expects that firms will routinely make use of stress testing and scenario analysis as a tool in the calibration and/or validation of their IRB Page 22 of 26

96 FSA 2009/ R approach parameters in order to increase the accuracy or, at least, the conservatism of the estimates. Stress testing should include a thorough exploration of various outturns different to the firm s normal expectations in order to give the firm a clear view of the potential for the forward-looking estimate to be different from that indicated by the primary data source(s). Firms should consider this as an integral part of their quantification process, and should have clear standards for how the results of the stress tests affect the final estimates used for the IRB approach parameters. (2) The stress test must be designed to assess the firm's ability to meet its capital requirements for credit risk under GENPRU 2.1 during all stages of the economic cycle and during an economic recession such as might be experienced once in 25 years downturn scenario based on forward looking hypothetical events calibrated against the most adverse movements in individual risk drivers experienced over a long historical period R A firm must be able to satisfy the FSA that it has adequate risk management processes to control those the risks to which the firm may be exposed as a result of carrying out credit risk mitigation. Those processes must include appropriate stress tests and scenario analyses relating to those risks, including residual risk and the risks relating to the intrinsic value of the credit risk mitigation. [Note: BCD Annex VIII Part 2 point 1] R A firm must take into account the illiquidity of lower-quality assets. The liquidation period must be adjusted upwards in cases where there is doubt concerning the liquidity of the collateral. A firm must also identify where historical data may understate potential volatility, e.g. a pegged currency. Such cases must be dealt with by means of a stress scenario assessments A G This paragraph provides guidance in relation to BIPRU R(8). In carrying out the stress testing programme, a firm should evaluate the simultaneous impact of individual stress scenarios on its counterparty exposures, its positions and the aggregate amount of margin calls that it would receive. A firm s stress scenarios should take into account the possibility that the liquidation period may be substantially longer than 5 days for repurchase transactions and securities lending or borrowing transactions, and 10 days for other types of securities financing transactions. Page 23 of 26

97 FSA 2009/72 Stress testing and scenario analyses of trading book positions R A firm must conduct a regular programme of stress testing and scenario analysis of its trading book positions, both at the trading desk level and on a firm-wide basis. The results of these tests must be reviewed by senior management and reflected in the policies and limits the firm sets A G The firm s stress testing programme should be comprehensive in terms of both risk and firm coverage, and appropriate to the size and complexity of trading book positions held R In carrying out the stress tests and scenario analyses required by BIPRU R, a firm must incorporate and take into account any other relevant stress tests and scenario analyses that it is required to carry out under any other provision of the Handbook, and in particular under BIPRU R where the firm has a VaR model permission G This paragraph gives guidance in relation to the stress testing programme that a firm must carry out in relation to its trading book positions. (1) The frequency of the stress testing of trading book positions should be determined by the nature of the positions. (2) The stress testing should include shocks which reflect the nature of the portfolio and the time it could take to hedge out or manage risks under severe market conditions. (3) The firm should have procedures in place to assess and respond to the results of the stress testing programme. In particular, stress testing should be used to evaluate the firm s capacity to absorb losses or to identify steps to be taken by the firm to reduce risk. (4) As part of its stress testing programme, the firm should consider how prudent valuation principles (see GENPRU 1.3) will be met in a stressed scenario G The stress testing and scenario analysis under BIPRU R should be taken into account under the overall Pillar 2 rule. Risk management standards: Stress testing R (1) A firm must frequently conduct a rigorous programme of stress testing. The results of these tests must be reviewed by senior management and reflected in the policies and limits the firm sets. (2) The programme must particularly address: Page 24 of 26

98 FSA 2009/72 (g) (h) (i) (j) (k) (l) ; and other risks that may not be captured appropriately in the VaR model (for example, recovery rate uncertainty, implied correlations and skew risk) full revaluation, or a reliable approximation, of positions; instant shocks as well as effects of longer term periods of stress; calibration changes under stressed conditions; secondary risk factors (such as volatility); basis risk; (m) systemic and localised stresses; and (n) other risks that may not be captured appropriately in the VaR model (for example, recovery rate uncertainty, implied correlations and skew risk) A G The firm s stress testing programme should be comprehensive in terms of both risk and firm coverage, and appropriate to the size and complexity of trading book positions held A G (1) The FSA expects firms to conduct regular stress testing in relation to their securitisation activities and off-balance sheet exposures. The stress tests should consider the firm-wide impact of those activities and exposures in stressed market conditions and the implications for other sources of risk, for example, credit risk, concentration risk, counterparty risk, market risk, liquidity risk and reputational risk. Stress testing of securitisation activities should take into account both existing securitisations and pipeline transactions, as there is a risk that these would not be completed in a stressed market scenario. (2) The frequency and extent of the stress testing should be determined by the materiality of the firm s securitisation activities and offbalance sheet exposures. (3) A firm should have procedures in place to assess and respond to the results produced from the stress testing and these should be taken into account under the overall Pillar 2 rule. Page 25 of 26

99 FSA 2009/72 Annex E Amendments to the Prudential sourcebook for Insurers (INSPRU) In this Annex, underlining indicates new text and striking through indicates deleted text A G This section sets out in greater detail the approach to be taken by a firm when carrying out the assessment of capital described in the preceding paragraph. This is the assessment referred to as an individual capital assessment. The rules in GENPRU 1.2 also (see GENPRU R (1)(c)) require a firm to identify and assess risks to its being able to meet its CRR in the future. GENPRU R is a general requirement for a firm to carry out stress tests and scenario analyses taking into account an appropriate range of adverse circumstances and events relevant to the firm s business and risk profile and to estimate the financial resources it would need to continue to meet the overall financial adequacy rule in the stress scenarios considered. As part of its obligations under GENPRU R, the firm must carry out stress tests and scenario analyses to estimate the financial resources it would need to support its business plans and continue adequately to cover its CRR and meet the overall financial adequacy rule over a time horizon of 3 to 5 years. This is a separate requirement from that to carry out an ICA, and guidance on this requirement is provided in GENPRU AG. In particular, firms should note that there is no requirement that the level of capital required as identified by the ICA should be equal to, or exceed, the CRR G GENPRU R requires a firm to carry out stress tests and scenario analyses for each of the major sources of risk identified in accordance with GENPRU R. A firm may also approach the assessment of the adequacy of its capital resources choose to carry out its ICA in another way than through the use of stress tests and scenario analyses. The method should be proportionate to the size and nature of its business G A Where a firm may choose chooses to carry out the assessment of the adequacy of capital resources its ICA through the use of stress testing and scenario analyses (noting that GENPRU R requires stress tests and scenario analyses to be undertaken to determine the overall financial adequacy of a firm s financial resources). Where used, such testing should reflect the potential range of outcomes for the risk being quantified, consistent with the prescribed confidence level for the ICA. Page 26 of 26

100 PUB REF: The Financial Services Authority 25 The North Colonnade Canary Wharf London E14 5HS Telephone: +44 (0) Fax: +44 (0) Website: Registered as a Limited Company in England and Wales No Registered Office as above.