The FSA get serious about Stress Testing
As part of a recent announcement on the importance of Stress Testing, Paul Sharma, FSA director of prudential policy, said:
“Stress and scenario testing should be an important element in firms’ planning and risk management processes. These changes send a clear signal to firms’ senior management that they need to engage in building a robust stress testing infrastructure as an important part of effective risk management, and use that to assess capital needs in a stress.”
This will force financial institutions to use scenarios to model risk and then to stress those scenarios. It also implies that they will need to take a quantitative approach to measuring the risk in scenarios. As if this isn’t enough, the announcement goes on to say that it expects firms to carry out “simultaneous system-wide stress testing”. That means having a common set of scenarios that are assessed across the enterprise and then compared and aggregated.
Right now, the majority of financial insitutions who are doing scenario analysis are using spreadsheets and this is clearly going to have to change. In partnership with some of our clients in insurance who are preparing for Solvency II and the Swiss Solvency Test, we have built a Scenario Analysis module in Sword that supports exactly what the FSA is asking for. Users create a set of scenario templates, determining what information is captured and what measures are required for each scenario. These can then be assigned to each of the relevant parts of the organisation for assessment and their status monitored. Once assessments are complete, the results can be used to analyse and stress the scenarios. Importantly, scenarios can draw on the data in the underlying risk framework, linking risk assessment, mitigation and losses to scenarios automatically, to inform and improve their assessment.
Scenario analysis and stress testing is an important step towards reducing risk in the financial institutions and I believe that, if the FSA supervise this initiative robustly, it will have a very positive effect.
Mike MacDonagh
Tags: FSA