“It is very difficult to resist the natural human tendency to fight the last war.” In June, Federal Reserve Chair Jerome Powell spoke about recency bias in the design of stress test scenarios that limits the ability of financial institutions to assess exposure to extreme shocks. In short, the focus of existing stress tests on credit losses, the impetus for the 2008 financial crisis, overshadowed the vulnerabilities that ultimately led to the bank failures this past spring: namely, high interest rate risk exposure and overreliance on uninsured deposits.
Vice Chair for Supervision of the Fed Michael Barr also recently said that “instead of thinking of a stressful scenario and then seeing how it would play out through the balance sheet of a firm, you look at a bank and you say, what would it take to break this institution?” Both statements from the Fed are a strong signal that your institution should have reverse stress testing in its risk management toolbelts. As the recent banking crisis showed us, an inadequate approach to stress testing can lead to severe consequences, including weak risk identification and mitigation, capital planning deficiencies, regulatory compliance issues, and even institutional failure.
In a reverse stress test, management assumes the institution will fail and works backward to determine the causes of failure. In other words, the outcome is the input, and the stress scenario is the output. This approach complements regular stress testing by identifying the conditions that could result in the institution’s failure. Anticipating these shocks is difficult, and stress testing with a scenario that fails to resemble the next crisis can misinform an institution about its level of vulnerability. Reverse stress testing helps to address these blind spots.
Powell and Barr’s comments come on the heels of a unique banking crisis that underscored the need for a multi-faceted stress testing approach. Whereas in 2008, massive credit losses triggered a global financial crisis, the crisis earlier this year began with a dramatic decline in the market value of government securities from surging interest rates.
Disaster struck with the failure of Silicon Valley Bank, which spurred a sudden loss of confidence in regional banks. As contagion spread through the industry, other regional banks failed under similar circumstances. It is clear that there were gaps in the banks’ stress testing processes, and reverse stress testing would have enhanced their risk awareness and mitigation strategies.
The figure below outlines the key steps to conducting a reverse stress test.
All the banks that failed relied heavily on uninsured deposits, leaving them vulnerable to a run by flighty depositors. In a reverse stress test, a bank would identify specific trigger points that could lead to a liquidity shortage, such as loss of depositor confidence due to poor financial performance or the failure of a competitor. This would allow the bank to develop informed mitigation strategies and assess capital adequacy to determine if raising additional capital is necessary. Ultimately, the exercise would equip the bank with a stronger understanding of its vulnerability to deposit runs and proactive risk management strategies to mitigate disaster.
Recent events serve as a stunning yet timely reminder of the importance of having a variety of tools in your analytical toolbelt. Regular and reverse stress testing enhance your ability to assess the resilience of your institution in different ways. Whereas regular stress testing is a top-down approach that provides a broader assessment of a bank’s overall risk exposure, reverse stress testing starts from the bottom-up and helps identify extreme risks and potential failure points that may not be captured in regular stress testing. By combining these approaches, banks can gain a more comprehensive understanding of the risks they face and take appropriate measures to safeguard against future catastrophic outcomes.
FI Consulting brings both the financial expertise and technological proficiency to help your bank navigate persistent and emerging challenges and keep pace with changing regulatory expectations. We’ve spent decades working with private sector financial institutions of all sizes and have vast experience helping clients strengthen their CCAR and DFAST stress testing processes.
If you’re interested in enhancing your institution’s risk awareness and strategic decision-making with reverse stress testing, email us at contact@ficonsulting.com or call us at 571.255.6900.
