Prudential Regulation Authority Rulebook

3.1

Both stress testing and scenario analysis are forward-looking analytical techniques, which seek to anticipate possible losses that might occur if an identified economic downturn or a risk event crystallises.

3.2

Stress testing typically refers to shifting the values of individual parameters that affect the financial position of a firm and determining the effect on the firm’s financial position.

3.3

Scenario analysis typically refers to a wider range of parameters being varied at the same time. Scenario analyses often examine the impact of adverse events on the firm’s financial position, for example, simultaneous movements in a number of risk drivers affecting all of a firm’s business operations, such as business volumes and investment values.

3.4

There are three broad purposes of stress testing and scenario analysis:

1. (i) as a means of quantifying how much capital might be absorbed if an adverse event(s) occurs;
2. (ii) to provide a check on the outputs and accuracy of risk models, particularly in identifying non-linear effects when aggregating risks; and
3. (iii) to explore the sensitivities in longer-term business plans and how capital needs might change over time.

3.5

The general stress test and scenario analysis rule in Internal Capital Adequacy Assessment 12.1 requires a firm to carry out stress tests and scenario analyses as part of its obligations under the overall Pillar 2 rule in Internal Capital Adequacy Assessment 3.1. Both stress tests and scenario analyses are undertaken by a firm to improve its understanding of the vulnerabilities that it faces under adverse conditions. They are based on the analysis of the impact of a range of events of varying nature, severity and duration. These events can be economic, financial, operational or legal, or relate to any other risk that might have an impact on the firm. Under Recovery and Resolution 2.4 in the PRA Rulebook, a recovery plan must contain a comprehensive range of options setting out actions that could be taken in a number of different scenarios and stresses.

3.6

As part of its obligation under the general stress and scenario testing rule in Internal Capital Adequacy Assessment 12.1, a firm should undertake a broad range of stress tests which reflect a variety of perspectives, including sensitivity analysis, scenario analysis and stress testing on individual portfolios as well as at a firm-wide level.

3.7

A firm should use the results of its stress testing and scenario analysis not only to assess capital needs, but also to decide if measures should be put in place to minimise the adverse effect on the firm if the risks covered by the stress test or scenario analysis actually materialise. Such measures might be a contingency plan or more concrete risk mitigation steps.

3.8

Stress tests and scenario analyses should be carried out at least annually. A firm should, however, consider whether the nature of the major sources of risks identified by it in accordance with the overall Pillar 2 rule in Internal Capital Adequacy Assessment 3.1 and their possible impact on its financial resources suggest that such tests and analyses should be carried out more frequently. For instance, a sudden change in the economic outlook may prompt a firm to revise the parameters of some of its stress tests and change its scenario analyses. Similarly, if a firm has recently become exposed to a particular sectoral concentration, it may wish to amend and/or add some stress tests and scenario analyses in order to reflect that concentration.

3.9

The PRA expects a firm to project its capital resources and capital requirements over a three to five year horizon, taking account of its business plan and the impact of relevant adverse scenarios. In making the estimate, the firm should consider both the capital resources required to meet its capital requirements under the CRR and the capital resources needed to meet the overall financial adequacy rule. The firm should make these projections in a manner consistent with its risk management processes and systems.

3.10

The firm should document its stress testing and scenario analysis policies and procedures, as well as the results of its tests in accordance with Internal Capital Adequacy Assessment 13.1. These results should be included within the firm’s ICAAP document.

3.11

The PRA expects a firm’s management body to be actively involved and engaged in all relevant stages of the firm’s stress testing and scenario analysis programme. This would include establishing an appropriate stress testing programme, reviewing the programme’s implementation (including the design of scenarios) and challenging, approving and taking action based on the results of the stress tests.

3.12

The PRA expects firms to assign adequate resources, including IT systems, to stress testing and scenario analysis, taking into account the stress testing techniques employed, so as to be able to accommodate different and changing stress tests at an appropriate level of granularity.

3.13

Firms should develop a range of firm-wide scenarios including some based on macroeconomic and financial market shocks for the purposes of their own stress testing. These scenarios should be developed so as to be relevant to the circumstances of the firm, including its business model, and the market(s) in which it operates.

3.14

In identifying an appropriate range of adverse circumstances and events in accordance with Internal Capital Adequacy Assessment 12.1, a firm will need to consider:

• the nature, scale and complexity of its business and of the risks that it bears;
• its risk appetite, including in light of the adverse conditions through which it expects to remain a going concern;
• the cycles it is most exposed to and whether these are general economic cycles or specific to particular markets, sectors or industries;
• the behaviour of counterparties, and of the firm itself, including the exercise of choices (for example, options embedded in financial instruments or contracts of insurance); and
• for the purposes of Internal Capital Adequacy Assessment 12.1, the amplitude and duration of the relevant cycle which should include a severe downturn scenario based on forward-looking hypothetical events, calibrated against the most adverse movements in individual risk drivers experienced over a long historical period.

3.15

The calibration of stress testing and scenario analyses should be reconciled to a clear statement setting out the premises upon which the firm’s internal capital assessment under the overall Pillar 2 rule in Internal Capital Adequacy Assessment 3.1 is based.

3.16

As part of its Annual Stress Testing framework, the Bank of England publishes a common stress scenario aimed at assessing the UK banking system’s capital adequacy. This scenario is run concurrently across a number of participating firms, on an annual basis.

3.17

Additionally, for firms not participating in the concurrent stress testing, the PRA publishes a macroeconomic scenario to serve as a guide and, where relevant, as a severity benchmark, for firms designing their own stress scenarios.

3.18

Firms should consider the relevance of the PRA’s stress scenario in the context of their business and specific risk drivers, and use this scenario as a starting point to build and calibrate their own scenarios. The scenario reflects minimum adverse conditions, through which firms should assess their ability to maintain minimum specified capital levels. This is particularly important for specialised firms, or firms whose business models are less affected by the PRA scenario (eg firms with major exposures to countries other than the United Kingdom, mono-lines, and investment banks).

3.19

More generally, all firms should continue to develop their own scenarios and ensure that these are as severe in relation to their business model as the concurrent stress testing scenario (for firms participating in concurrent stress testing) or the scenario published by the PRA (for all other firms).

3.20

The PRA may ask some firms to run concurrent stress test scenarios or the PRA scenario as part of their range of stress scenarios for Pillar 2 capital planning. Asking firms to run common scenarios, or scenarios that are broadly comparable in terms of severity (eg for firms with different business models) will allow supervisors to more easily compare and benchmark individual results and firms' approaches to stress testing.

3.21

In identifying adverse circumstances and events in accordance with Internal Capital Adequacy Assessment 12.1, a firm should consider the results of any reverse stress testing conducted in accordance with Chapter 15 of the Internal Capital Adequacy Assessment Part of the PRA Rulebook. Reverse stress testing may be expected to provide useful information about the firm’s vulnerabilities for the purpose of meeting the firm’s obligations under Internal Capital Adequacy Assessment 12.1. In addition, such a comparison may help a firm to assess the sensitivity of its financial position to different stress calibrations.

3.22

In carrying out the stress tests and scenario analyses required by the general stress and scenario testing rule in Internal Capital Adequacy Assessment 12.1, the PRA expects a firm to consider any impact of the adverse circumstances on its capital resources. In determining whether it would have adequate financial resources in the event of each identified severe adverse scenario, the firm should:

• only include financial resources that could reasonably be relied upon as being available in the circumstances of the identified scenario; and
• take account of any legal or other restriction on the use of financial resources.

3.23

In making the estimate required by Internal Capital Adequacy Assessment 12.3, a firm should project both its capital resources and its required capital resources over a time horizon of three to five years, taking account of its business plan and the impact of relevant adverse scenarios. The firm should consider both the capital resources required to meet its capital requirements under the CRR and the capital resources needed to meet the overall financial adequacy rule. The PRA’s approach to projecting the Pillar 2A component of capital requirements is described in Chapter 9 in PRA Statement of Policy ‘The PRA’s methodologies for setting Pillar 2 capital’.³⁴ The PRA considers this approach to be appropriate for most firms. The firm should make all these projections in a manner consistent with its risk management processes and systems as set out in Internal Capital Adequacy Assessment 3.1.

3.24

When deciding the planning horizon over which to conduct their analysis, firms should consider how long it might take to recover from any loss. The time horizon over which stress tests and scenario analyses should be carried out will depend on, among other things, the maturity and liquidity of the positions stressed. For example, for the market risk arising from the holding of investments, this will depend upon the extent to which there is a regular, open and transparent market in those assets, which would allow fluctuations in the values of the investments to be more readily and quickly identified.

3.25

In projecting its financial position over the relevant time horizon, the firm should:

• reflect how its business plan would respond to the adverse events being considered, taking into account factors such as changing consumer demand and changes to new business assumptions;
• consider the potential impact on its stress testing of dynamic feedback effects and second-order effects of the major sources of risk identified in accordance with the overall Pillar 2 rule in Internal Capital Adequacy Assessment 3.1;
• estimate the effects on its financial position of the adverse event without adjusting for management actions;
• separately, identify any realistic management actions that the firm could, and would, take to mitigate the adverse effects of the stress scenario; and
• estimate the effects of the stress scenario on its financial position after taking account of realistic management actions.

3.26

The PRA expects firms to identify any realistic management actions intended to maintain or restore capital adequacy. A firm should reflect management actions in its projections only where it could, and would, take such actions, taking account of factors such as market conditions in the stress scenario and any effects upon the firm’s reputation with its counterparties and investors. The combined effect on capital and retained earnings should be estimated.

3.27

To assess whether prospective management actions in a stress scenario would be realistic, and to determine which actions the firm could and would take, the PRA expects a firm to take into account any preconditions that might affect the value of management actions as risk mitigants. It should then analyse the difference between the estimates of its financial position over the time horizon, both gross and net of management actions, in sufficient detail to understand the implications of taking different management actions at different times, particularly where they represent a significant divergence from the firm’s business plan.

3.28

A firm should use the results of its stress testing and scenario analysis not only to assess capital needs, but also to decide if measures should be put in place to minimise the adverse effect on the firm if the risks covered by the stress or scenario test materialise. Such measures might be a contingency plan or more concrete and immediate risk mitigation steps.

3.29

Where a firm is a member of a group in which a qualifying parent undertaking³⁵ has a double leverage ratio above 100%, or is projecting one above 100%, the PRA expects the firm to assess and mitigate the risks of double leverage, including the cash-flow risks incurred by its qualifying parent undertaking as part of its stress testing and scenario analysis. For this purpose, ‘double leverage ratio’ is defined as a qualifying parent undertaking’s common equity capital investment in its subsidiaries,³⁶ divided by its own common equity capital.

3.29A

For purposes of calculating the double leverage ratio, ‘qualifying parent undertaking’s common equity capital investment in its subsidiaries’ is defined as the holding company’s investment in common equity of its subsidiaries. For the avoidance of doubt, investment in Additional Tier 1 instruments, calculated according to CRR Article 61, should not be included. For purposes of calculating the double leverage ratio, ‘own common equity capital’ is defined as shareholder’s equity less intangible assets, less deferred tax assets (DTAs), less Additional Tier 1 Instruments.

1. (i) ‘DTAs’ has the same meaning as under the applicable accounting framework.
2. (ii) 'Intangible assets' has the same meaning as under the applicable accounting framework and includes goodwill.
3. (iii) Additional Tier 1 instruments should be calculated according to CRR Article 61.
4. (iv) 'Applicable accounting framework' refers to the accounting standards to which the institution is subject under Regulation (EC) No 1606/2002 or Directive 86/635/EEC.

3.30

These expectations also apply where the firm is a member of a group that uses a different definition of double leverage, or calculates double leverage in respect of a grouping of companies,³⁷ and its double leverage ratio is over 100%, or is projected to be over 100%. In these circumstances, information should be provided in respect of the qualifying parent undertaking’s double leverage ratio as set out above, as well as in respect of the aggregate double leverage ratio in those circumstances where double leverage occurs at different levels in the group, as set out above. Should the firm’s own methodology differ from the one described in this document, it should provide information in respect of its own internal approach, as well as the approach described in this document.

3.31

Specifically, in its ICAAP document the PRA expects the firm to:

• provide details of the qualifying parent undertaking’s double leverage ratio and the projected double leverage ratio on a forward-looking basis over a three- to five-year time horizon;
• explain how the risks of double leverage are assessed and managed, including any mitigating factors in place (eg any unencumbered liquid assets held by the qualifying parent undertaking to cover the risk of a shortfall in income to meet its interest obligations);
• develop and analyse relevant stress or recovery scenarios, including where the qualifying parent undertaking’s inflows from its subsidiaries are significantly reduced and/or market conditions make it difficult to rollover existing debt. Specifically, it should consider any constraints that have been, or might be, imposed on dividend payments from an entity established outside the United Kingdom to its qualifying parent undertaking;
• provide information on the qualifying parent undertaking’s expected quarterly inflows and outflows under both normal and stressed conditions over a three- to five-year time horizon; and
• identify what management actions the firm would take in a stress to manage the risks of double leverage and the impact those management actions would have on the qualifying parent undertaking’s inflows and outflows and on its double leverage ratio.

3.32

Firms for which the PRA is not the global consolidating supervisor are not expected to conduct this assessment or provide the relevant analysis in their ICAAP documents, unless the PRA requests otherwise.

3.33

Under the SMR,³⁸ firms are required to allocate a PR for managing the allocation and maintenance of the firm’s capital, funding and liquidity to an individual performing an SMF.³⁹ The PRA expects:

• the SMF allocated this PR to ensure that the firm conducts the assessments specified in paragraphs 3.29 to 3.31 and to document them in the firm’s ICAAP submissions; and
• firms to ensure this expectation is explicitly reflected in the relevant SMF’s Statement of Responsibilities.