Stress-testing
What lessons can registered providers learn from the banking sector?
GOVERNANCE
Image: Istock
Patrick Alderman
Director, Link Treasury Services
As board members of registered providers (RPs) will know, stress-testing has risen to prominence and increasingly entered the public lexicon, since the 2007-08 global financial crisis. Today, it plays an integral role in the Bank of England’s macroprudential framework for banking supervision, and its principles are increasingly being adopted in other sectors.
For instance, the Regulator of Social Housing (RSH) requires stress-testing to accompany its annual Financial Forecast Return (FFR) submission and it weighs heavily on the outcome of In-Depth Assessments. The RSH’s governance standards state that an RP’s board must review and approve its business planning, risk and control framework annually, and this must include conducting stress tests.
Before joining the housing sector, I had worked in treasury teams at two of the largest UK banks. This was a period when the banking sector was experiencing transformational reforms and I spent most of my time working on projects addressing changes to regulations. These ranged from building infrastructure to implement Basel III, designing new group structures in response to ring-fencing legislation, or applying for banking licences in EU countries following Britain’s withdrawal. Across all these activities, one theme was inescapable: stress-testing.
“Before joining the housing sector, I had worked in treasury teams at two of the largest UK banks. This was a period when the banking sector was experiencing transformational reforms and I spent most of my time working on projects addressing changes to regulations.”
Sector similarities
After leaving banking, my first role in housing was as head of treasury and business planning at a medium-sized RP. In many ways the sectors are comparable in terms of economic exposures, capital structures and level of regulatory oversight, and I began the process of orientating myself by reading through the RSH’s Regulating the Standards.
I was initially interested by the fact that stress-testing was now being adopted outside banking, but more than that, the way in which expectations relating to stress-testing were communicated. However, a phrase that really stood out to me was that stress tests should be, ‘sufficiently severe but plausible’.
On the face of it, this sounds very sensible, but scratch a little deeper and it becomes slightly problematic: there is an inherent trade-off between severity and plausibility. As you start making a scenario more and more severe it becomes less likely, and this, in turn, makes it less plausible.
Board confusion
It wasn’t long before I was attending board meetings and observed that there was a great deal of discussion around the question of what constitutes a severe but plausible scenario. More fundamentally, whether the implications of risks to the delivery of the business plan were being effectively considered. I wondered if some insight from the banking sector might help to inform this debate.
Aside from the stress-testing required by the Bank of England, which often receives a high-level of media attention, banks conduct stress-testing as part of their annual planning cycles. Stress-testing is accepted as best practice and serves to demonstrate the resilience of financial plans.
Risk probability approach
Practically, plausibility is used interchangeably with likelihood, and likelihood can be expressed in terms of probabilities. So, typically, banks develop stress scenarios that, in their assessment, would occur with a probability of (say) 5% or 1%. These scenarios are designed by looking at historical trends of risk parameters, the correlations between them, while accounting for economic indicators reflecting the current macroeconomic environment.
Adopting this sort of approach within the housing sector could be particularly beneficial. It would enable boards to frame their risk appetite in terms of the level of risk they would accept for the business plan failing. Correspondingly, when undertaking reverse stress-testing, it can help establish the likelihood that the plan will fail. Further, it promotes thinking about the likelihood of a scenario emerging, rather than arbitrarily inventing speculative market-wide and idiosyncratic shocks of varying severity.
Noting the recent Living Will Procedure published by the G15, the value attributed to methodologically sound and rigorous stress-testing frameworks is only likely to increase.
Ultimately, stress-testing should demonstrate that boards understand both the likelihood and impact of risks materialising under different scenarios. This is essential when providing assurance that the organisation has a robust and prudent business planning, risk, and control framework that is effective in its objective.
