ARCLogics Sword Blog

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

“An organisation’s risk measurement system must be closely integrated with their day-to-day risk management processes.” The FSA’s Use Test aims to ensure that risk measurement that is carried out for regulatory purposes is not separate from but is embedded within their risk management practices. In my experience however, it is surprising how often a firm’s risk management practices are themselves not embedded in their day-to-day business processes. All too often, core risk management processes such as risk and control assessment, KRI assessment and the capture of loss and near miss events is carried out not by the business staff who are closest to them but by a separate risk management or compliance function.

This has echoes back to the 1980’s and 1990’s when we were introduced to Total Quality Management with the realisation that if you have a separate quality assurance team, the rest of the workforce has a tendency to assume that quality is someone else’s problem. As with quality, this has the potential to be a significant factor with risk management. Identifying and trying to mitigate risk should be the concern of every employee, not just the risk and compliance teams. Only when business staff are actively involved in the management of risk does genuine best practice have the chance to evolve within an organisation.

Many organisations have compromised, with an intermediate approach in which risk and compliance staff gather information from business staff on an occasional basis. On the surface, this sounds like an improvement but it too has significant weaknesses. Firstly, timing, the gap between the event and its recording is itself a risk. More importantly, the potential role of business staff in identifying risks and losses or near misses and their involvement in devising mitigation strategies affects not just the effectiveness of risk management but its efficiency as well.

So, by involving business staff in the risk and compliance processes, organisations can reduce the incidence and seriousness of risk and cut the amount they spend on doing so ………… the FSA has it right!

Mike MacDonagh