Risk Management

Why (and How) to Stress-Test

Done right, stress testing helps companies imagine the worst — and prepare accordingly.
Nicolas KunghehianDecember 14, 2011

In recent years, stress testing has become more important, fueled by regulatory requirements and the weakened economic environment. Indeed, many companies are undertaking stress testing for more than just regulatory compliance; a growing number are integrating the process into business-planning and strategy-setting procedures. But stress testing has a long way to go before it becomes a fully embedded risk-management practice.

Stress testing is an important component of risk management. It defines a plausible scenario that could have important consequences for a company. Doing this exercise helps determine an adequate solution should the crisis scenario happen. Let us try to define one of the other benefits: a CFO is constantly under pressure to find new funding sources. To reach this goal, investors must be convinced of a company’s stability. Stress tests can be a very useful tool to restore or maintain confidence in a company. A CFO will never be keen to disclose too much information; however, presenting different outcomes of a stressed scenario will provide valuable transparency.

Imagine a company publishing various crisis scenarios (for example, default of a European country, an increase in oil prices, or movements in currency exchange rates) and their potential impact on its operations, finances, or both. Of course, there may be a negative outcome overall. But the CFO has the opportunity to prove that the company will survive and face relatively low losses. Investors invest only if they have enough clear information to assess the risk of an investment appropriately — and a stress test could tip the scale in the capital-seeking company’s favor.

Having a comprehensive stress-testing framework requires greater collaboration between the CFO and the business lines. Scenarios for stress testing are best developed with the participation of multiple teams. The objective of this collaboration is to generate scenarios that are both plausible and relevant. For example, before opening an office in a new country, a CFO needs the help of people who know the specifics of the area; that is, the evolution of salaries, the trend in real estate prices, and data on currency exchange rates.

In creating a stress-testing culture, though, there are hurdles. Business lines generally have difficulty creating appropriate scenarios: managers argue that the scenarios may not be plausible or that imposing limits based on the scenarios may cut into the company’s enterprise and short-term margins. A good stress-testing framework must be able to reconcile such issues. The second challenge concerns data, models, and tools. Creating a comprehensive framework requires developing or enhancing the company’s data-management systems. Quality and granularity are essential for a correct quantitative risk measure. Quantitative modeling ability to translate scenarios into risk drivers is also essential. (Business lines often have good insight to help implement these models.) The third and final challenge is developing the tools necessary to process data, the main benefit of which will be to give risk analysts ample time to conduct more in-depth analyses that will better define the company’s global risk appetite.

Here are four tips for helping to overcome these challenges:

• Consider developing a dedicated program designed to educate teams on the benefits of the stress-testing framework.

• Invest in dedicated resources and tools. A report compiling stress measures gathered from different areas of the company is insufficient. Stress measures must be coherent — calculated using the same kind of data and the same methodology. This is one reason advanced companies have invested in dedicated teams, a single data warehouse, and uniform methodologies.

• Use stress testing as a key input to risk appetite. Stress testing should be embedded in the company’s risk culture, to create a virtuous circle in which risk appetite and stress testing work together to help the company meet both regulatory requirements and performance objectives.

• Put yourself (the CFO) at the heart of the process. The CFO will always be held responsible if the company suffers huge losses because of a misunderstood risk. But he or she is also in a position to convince both the board and senior management of the positive impact that stress testing will have on the company’s margins and its ability to raise capital.

Nicolas Kunghehian is a business development officer for EMEA, Moody’s Analytics. He is a thought leader on asset liability management, liquidity, and market risks for the EMEA region.

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