Companies or firms operate in dynamic and somewhat complex environments where they face multiple risks, which include financial, strategic, compliance, operational risk etc. These risks could threaten the financial goals of the company. Risk management plays a critical role in ensuring the stability and resilience of these firms. In a crisis, markets can suddenly become very illiquid, and the stress situation could expose a firm to vulnerable impacts on its financial position. Stress testing is a risk management tool that supports firms to prepare against adverse financial situations. This article will explore the concept of stress testing in risk management and the significance of stress testing in ensuring the stability, resilience, and success of firms.

Each organization or firm has its unique risk profile, which refers to the identification and evaluation of potential risks the firm may face in achieving its objectives. The risk profile comprises of both internal and external risks and is influenced by various factors. Stress testing allows firms to identify vulnerabilities, quantify potential losses and provide insights into the weaknesses of the firm’s risk profile. Stress testing involves subjecting a firm’s portfolio to various hypothetical scenarios that may lead to significant financial impact.

Firms need to be better prepared to weather a severe financial storm. The financial crisis of 2008-09 had serious worldwide economic impact due to the collapse of the housing market bubble, exposing significant weakness in risk management and stress testing. The unprecedented COVID-19 pandemic presented challenges like extreme volatility in financial markets worldwide, increased credit risk, business risk, supply chain disruptions and liquidity risk. The recent banking crisis, which was in part triggered by macroeconomic factors, such as rise in interest rates, posed significant risks that include systemic risk, credit risk, market risk, recession, and deterioration of trust in financial institutions.

This turn of events emphasizes the necessity for firms to prepare in advance, conduct scenario analysis, develop contingency plans for extreme events and carry out rigorous stress testing. Thus, when normal market conditions breakdown, stress testing is well designed to assess the degree of vulnerability in these situations. The primary objectives of stress testing are as follows:

1) Risk Identification and Management

Stress testing helps to identify potential risk and vulnerabilities that may not be evident under normal market conditions. By subjecting portfolios to extreme events, firms can uncover hidden vulnerabilities and areas of weakness.

2) Capital Adequacy and Liquidity Management

Stress testing evaluates whether the firm has sufficient capital to absorb losses that could adversely impact the organization during severe events.  Stress testing helps in assessing the adequacy of liquidity buffers in case of wide stress events.

3) Decision Making

A firm would benefit from stress testing, as it enhances its informed decision-making process by providing valuable insights into the risk profile in light of adverse economic conditions. This, in turn, would facilitate the development of risk mitigation plans across the range of stressed conditions.

Hence, by making stress testing an integral part of enterprise-wide risk management, a firm can recognize its importance. Stress testing aids in defining risk appetite, setting exposure limits, evaluating strategies and supports decision making process in strategic planning.

Various type of stress tests are performed in risk management. Let’s look at the widely used tests.

1) Scenario Analysis

Scenario analysis involves the development of historical, probabilistic, or hypothetical scenarios to analyze the impact of different scenarios. This helps firms understand how different variables, such as interest rate, inflation rate, exchange rate, stock price, commodity price, etc. can affect their financial position. We have been using scenario analysis extensively to show our clients the complex dependencies between several risk factors and their related key performance indicators.

2) Reverse Stress Testing

This type of stress testing assumes a known adverse outcome and then seeks to identify the circumstances that would lead to such an outcome. For example, at Ehata we have illustrated that assuming a rapid increase in interest rates for a firm, what magnitude of shock would it take for a significant deterioration in its Economic value of Equity? What could be the probability of such a shock?

3) Sensitivity Testing

This type involves an incremental change in a risk factor (or on a limited number of risk factors) with the aim of providing answers to what-if questions.  For example, for an existing interest rate swap, how much the Mark-to-Market (MtM) value is sensitive to 25 basis points (bps) change or a 50-bps change, either in the positive or negative direction?

While regulators may not mandate stress testing for all firms, it is widely recognized as a best practice in risk management. However, in order to ensure an extensive assessment of risk, it is essential for a firm to build a comprehensive framework for modeling various scenarios. By following the basic principles of stress testing, a firm can enhance its ability to identify and manage potential risks proactively.

The basic principles that could be followed are that stress testing planning must be plausible, consistent, adaptive, and reportable. Stress testing should enable the understanding of the cause and effect relationship between stresses and changes in the risk profile of the firm. The assessment should help the firm develop action plans to address identified risks, enhance capital buffers, protect earnings, and improve the overall risk management process.

By utilizing stress testing as a forward-looking risk management tool, we can evaluate the potential impact of unexpected events in a firm’s financial position and build the case for strategic hedging. Whether it is scenario-based, reverse, sensitivity analysis or any other type of stress testing, the insights gained from these exercises help firms enhance their resilience, ensure business continuity, enable strategic decision-making, and play a critical role in maintaining stability and financial soundness.