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: piers.haben@fsa.gov.uk 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)