The recent occurrences of black swan events with far-reaching, global consequences have pushed forward-thinking organizations to reevaluate and bolster their risk postures in the face of ongoing uncertainty. From supply chain disruptions to increased cyber attacks, threats to enterprise resilience must be countered with the proper tools and methods for maintaining resilience, taking into account unlikely but potentially devastating scenarios and how to mitigate those risks.
In this article, we’ll explore the various facets of stress testing and how it can be used to validate and battle-harden your enterprise risk management process against unknown risks.
What is Stress Testing?
Stress testing in a risk management context aims to analyze, contextualize, and quantify the impacts of all feasible scenarios—both likely and extreme/outlier events—to ensure the proper preparations and “shoring-up” resources are in place to weather extreme adversity. Risk management tools like RMIS software provide a single interface for identifying and assessing risks/controls, running stress tests under specific risk conditions, and creating plans for accepting, transferring, treating, or eliminating identified risk drivers.
In many cases, stress testing is both performed as part of internal, enterprise risk management initiatives, as well as to meet regulatory compliance requirements. For example, enterprises and oversight bodies may need to ascertain that adequate resources (e.g., human resources, parts, capital, liquid assets) are on hand to weather ongoing disruptions and hardships.
Types of Stress Testing
The goal of stress testing enterprise risk management processes is to assess the impact of changing a particular variable, with all other factors held constant. Chiefly, assessments take place without regard to whether or not that change is likely to occur in reality—for example, the recent pandemic was a highly unlikely, catastrophic world event; nonetheless, many government agencies and private organizations had already established a pandemic preparedness framework based on previous stress testing and assessments.
Several types of testing fall under the stress testing umbrella. For example, the goal of a reverse stress test is to determine how much change is required to bring an organization to financial collapse. In these cases, the tests help enterprises determine various modes of failure, such as continued disruption to supply chains.
In a scenario test, an assessment is made regarding an event’s financial impact to provide a holistic picture of possible circumstances, laying out the ramifications and effects on all aspects of the organization. Again, these assessments are made without regard to the event’s likelihood.
Stress Testing Benefits for Enterprise Risk Management
The following are key benefits for organizations looking to incorporate stress testing into their enterprise risk management processes.
Augmenting Natural Catastrophe Analysis
Environmental and natural disaster/catastrophe risk analysis incorporate sophisticated simulation models based on existing data sets; subsequently, the efficacy of models for informing decision-making may be limited for certain risk types/perils (e.g., pandemic, earthquake, tornado) and locations/regions (e.g., U.S., Northern Europe). Stress tests and scenario tests can augment natural catastrophe analysis, and supplement stochastic models where they fall short.
Complementing Existing Models & Frameworks
Stress tests can either be used as a primary measure for assessing risk, or as a method for validating and calibrating more complex risk modeling methods. For example, many organizations incorporate probabilistic simulation in their modeling efforts. In these cases, uncertainties around specific inputs are handled as probability distributions, with any random events impacting the system also addressed therein.
Stress testing is simpler in that it does not require the selection of probability levels or dependency knowledge for linked risks. For this reason, it's an ideal complement to existing models and frameworks for assessing specific risk levels, measuring aggregate risk levels, setting risk tolerances/controls, evaluating measures such as hedging and insurance, and more.
Assessing Financial Impact
Stress testing serves to warn a firm’s management of potential adverse events arising from the firm’s risk exposure and goes further to give estimates of the amount of capital needed to absorb losses that may result from such events. Stress testing can be combined with measurement of the risk such as the Value-at-Risk (VaR) and the Expected Shortfall (ES) to give a detailed picture of the risks facing a financial institution.
Driving Business Strategy
Stress testing can help to inform business strategy and allow organizations to achieve operational resilience in the face of uncertainty. For example, product pricing levels can be adjusted accordingly to account for any potential negative impacts on manufacturing and/or supply chain. For new products introduced into the market, limited data may exist (or none at all); in these cases, hypothetical stress testing is critical for generating reliable estimates around losses and impacts to the bottom line.
Satisfying Compliance Requirements
As mentioned previously, stress testing is often a requirement enforced by regulators and oversight bodies. For example, Basel III is a global regulatory standard for bank capital adequacy, stress testing, and market liquidity risk and requirements. As an extension of the Basel II Framework, Basel III includes stress testing as a requirement for banks using the Internal Models Approach (IMA) to model market risk and internal, ratings-based credit risk modeling approaches. Adopting banks are required to use stress testing for determining required levels of capital.
Enabling Enterprise Risk Management
In short, incorporating stress testing into your enterprise risk management processes helps to foster a risk-oriented culture across the organization. Instead of passive planning in response to historical events, stress testing enables leadership, management, and planners to proactively map out the financial impact of events—no matter how unlikely— and create relevant responses and measures to mitigate losses. To learn more about stress testing for your enterprise risk management processes, give Ventiv's enterprise risk management platform a test drive today.
