From a capital (and liquidity) planning perspective, the period March / April is likely intense for many institutions who are in the late- or final stage of the ICAAP process, assessing the capital position in a short-, mid- and long-term perspective. In dialogue with our clients, the outbreak of Covid-19 has put many institutions in a dilemma:
On the one hand, presenting an ICAAP not considering the consequences of Covid -19 to the board is not an option. The severe macro-economic consequences and their impact on the PnL, balance sheet and own-funds position must be part of the baseline scenario.
On the other hand, stress testing frameworks highly dependent on the formulation of hypothetical scenarios face the challenge of constructing consistent economic projections from an already stressed position, and the challenge becomes borderline impossible due to the high degree of uncertainty associated with the existing macro-economic projections.
Enter reverse stress testing. FCG recommend institutions that are facing this dilemma to alter the approach to stress testing under the current circumstances and focus more on a reverse stress testing approach based on stand-alone- and aggregated sensitivity tests. Setting the own-funds threshold to be evaluated will depend on the current own-funds position, long-term dividend policies, funding structure and, of course, regulatory requirements, and setting the threshold may be a challenge in itself but is far from impossible once the risk committee and senior management has initiated the dialogue on the topic.
Once a target state has been formulated, the next step is to start evaluating the revenue streams and balance sheet composition in order to find the events that trigger the capital position to deteriorate down to or below the threshold. Collaboration between the various business lines and group functions becomes critical success factors when identifying the sensitivity contribution from the various components.
Reverse stress testing is a powerful risk management tool that plays an important role in identifying, measuring and mitigating risks, and its capacity is even more important when an institution is facing idiosyncratic or market-wide stress. Finally, it enables a dialogue with the board that may be more transparent and tangible in comparison to running additional hypothetical scenarios during already stressed circumstances.