Reverse stress testing has been advised by the FSA (Financial Services Authority) in the UK who have said that stress testing in UK financial firms is too weak to prevent another Northern Rock crisis. They are advising firms to do “reverse stress tests” to identify high-risk scenarios. The want banks, building societies, investment firms and insurers to consider scenarios that may cause their firms business to become unviable.

Normally ‘stress testing’ refers to something banks do when considering clients, they stress loan rates taking into account potential rate hikes, but they have never been asked to stress test their own business models in the way they are presently being asked to do.

In a consultation paper published yesterday, the FSA said UK firms were still not testing themselves against sufficiently severe scenarios. The proposed changes are intended to better reflect the importance that is attached to robust stress and scenario testing and to clarify the Regulators expectations of firms.

“Stress and scenario testing should form a key part of a suite of tools used by a firm’s senior management in making integrated business strategy, risk management and capital planning decisions. Recent market events have shown the importance of strong governance in firms. Senior management at less affected firms had more successfully established comprehensive firm-wide risk assessment processes in which
thoughtful stress and scenario testing played a material part, allowing better-informed and more timely decision-making.”In a reverse stress test, firms would need to identify worst case scenarios and describe the precautions they were taking against them. Survival could be threatened by a general loss of market confidence, even if the firm still had adequate regulatory capital, the FSA added.

Our own regulator would do well to consider some of the proactive ideas being put forward by the British regulator, there is no cure for financial upheaval, but the right measures could at least serve as a much needed secondary prophylaxis.