Prudential Regulation Authority Rulebook

4.1

This chapter on reverse stress testing was added to this supervisory statement on 3 August 2015 following consultation on proposals in CP17/15.⁴⁰

4.2

Reverse stress testing is a risk management tool used to increase a firm’s awareness of its business model vulnerabilities. Firms in scope of Chapter 15 of the Internal Capital Adequacy Assessment Part of the PRA Rulebook must carry out reverse stress testing in accordance with Chapter 15 of that Part. This includes requirements on the firm to reverse stress test its business plan; that is, to carry out stress tests and scenario analyses that test its business plan to failure.

4.3

Business plan failure in the context of reverse stress testing should be understood as the point at which the market loses confidence in a firm and, as a result, the firm is no longer able to carry out its business activities. Examples of this would be the point at which all or a substantial portion of the firm’s counterparties are unwilling to continue transacting with it or seek to terminate their contracts, or the point at which the firm’s existing shareholders are unwilling to provide new capital. Such a point may be reached well before the firm’s financial resources are exhausted.

4.4

The PRA may request a firm to quantify the level of financial resources which, in the firm’s view, would place it in a situation of business failure should the identified adverse circumstances crystallise.

4.5

In carrying out the stress tests and scenario analyses required by rule 15.2 of the Internal Capital Adequacy Assessment Part of the PRA Rulebook a firm should at least take into account each of the sources of risk identified in accordance with Internal Capital Adequacy Assessment 3.1.

4.6

Reverse stress testing should be appropriate to the nature, size and complexity of the firm’s business and of the risks it bears. Where reverse stress testing reveals that a firm’s risk of business failure is unacceptably high, the firm should devise realistic measures to prevent or mitigate the risk of business failure, taking into account the time that the firm would have to react to these events and implement those measures. As part of these measures, a firm should consider if changes to its business plan are appropriate. These measures, including any changes to the firm’s business plan, should be documented as part of the results referred to in rule 15.4 of the Internal Capital Adequacy Assessment Part of the PRA Rulebook.

4.7

In carrying out its reverse stress testing, a firm could consider scenarios in which the failure of one or more of its major counterparties or a significant market disruption arising from the failure of a major market participant, whether or not combined, would cause the firm’s business to fail. For an RFB, this supervisory statement should be read in conjunction with SS8/16⁴¹. SS8/16 sets out the PRA’s expectation that an RFB sub-group should consider the failure of group entities that are not members of the RFB sub-group as part of reverse stress testing.

4.8

Firms may choose to use reverse stress testing as a starting point for their recovery plan scenarios.