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Reverse Stress Tests Explained
The Basel Committee and the CEBS are both issuing consultation papers calling for banks to perform reverse stress tests, in addition to regular stress tests. Going beyond traditional stress tests, reverse stress tests serve to validate and analyse a specific outcome of stress (e.g. bankruptcy). The goal is to analyse the causes that could lead to this outcome.
Reverse stress tests enable banks to deal with those risk factors to which they are exposed in a qualified manner. Reverse stress tests can range anywhere on a scale between purely qualitative and purely quantitative. Unlike forward stress tests, which focus on the dimensions of the losses, reverse stress tests analyse how risk factors operate and how they are connected.
Quantitative reverse stress tests require a defined potential loss: e.g. the maximum risk capital that would still allow the bank to survive. The tests then examine the possible changes to the market parameters that would lead to this loss.
An Easy Solution
The FlexFinance Reverse Stress Test solution addresses these issues in a ‘lightweight’ application. Expanding on existing stress tests, this solution is easy to integrate into SAP architecture, for example. In reverse stress testing, a number of solutions are determined due to the high number of risk factors and combinations of risk parameters. These solutions are calculated using iteration. The combination of several risk factors then creates a ‘risk landscape’ that shows the value combinations that threaten the bank’s existence.
