Peacetime stress‑testing applications

Leo Sadovy, analytics consultant, risk, finance and banking, and solution lead for SAS‘s scenario analysis and stress-testing solution, sets out the key role of strong decision-making and the importance of being able to innovate and respond to adverse scenarios at speed

The best explanation of the purpose of business intelligence, artificial intelligence and analytics in business environments is simply this: better decisions, faster.

The same can be said for stress-testing. Beyond its wartime function of staving off financial collapse and catastrophe under adverse and severe economic conditions, stress-testing has a peacetime purpose in the domain of decision support: better decisions, faster.

While most business-as-usual (BAU) conditions and decisions fall far short of anything resembling severe, they still need to be co‑ordinated with regulatory processes, ensuring ongoing capital adequacy. Hence, business decisions made to take advantage of new market opportunities, product offerings and technologies, or to respond to competitive market pressures, go-to-market delays or macroeconomic impacts, need to be pretested for capital adequacy.

This leads to the primary driver of the peacetime application of stress-testing: thresholds.

Thresholds are key to using scenario-driven approaches to guide management action. Thresholds represent transitions from BAU to situations requiring management action to implement corrective action or a ‘plan B’ (which is still short of adverse), based on basic stress/scenario-driven parameters. The basic principles are:

• Defining the scope and boundaries of your BAU plan A.
• As long as you remain within those boundaries, your management actions are primarily focused on tactics and execution.
• Having well-defined boundaries or thresholds that indicate when you have left the BAU zone and which adjacent scenario you have moved into (plan B1, plan B2, plan B3, etc).
• You have a predefined and pre‑approved operating plan, budget/resource allocation plan and management incentive plan developed and ready to implement for each adjacent scenario.
• Regulated financial institutions should add an additional step to that list:
• To stress-test each adjacent scenario and know ahead of time what provision and capital allocation actions need to be taken to remain in compliance and on a sound footing for continued operations. For example, plan B3 might simply require an increase in reserves for a limited time, whereas plan B5 might demand a restructuring of funding sources or a selloff of the impacted portion of your portfolio.

 

The benefits of such a scenario-driven approach are many, but three in particular are crucial:

• When making cuts, freezes or taking other actions, only affected areas need to be targeted (products, segments, lines of business or territories). Unaffected operations can continue within their previous BAU zones.
• Strategic programmes and self-contained/funded projects do not need to be altered. If, for example, your long-term strategy hinges on an enterprise-wide, customer data integration initiative, you should avoid broad cuts impacting its success.
• The most important benefit of employing predefined plan Bs is the speed at which you can effect change, unhindered by the typical multi-month exercise of renegotiating budgets and incentive plans. All of management, from top to bottom, should know the parameters of each scenario, which resources will be cut or reallocated under each plan B and, most importantly, what their incentive plan will look like under each adjacent scenario. Often, the biggest impediment to effective management action in such cases is feet-dragging and even obstruction caused by management teams trying to protect resources and compensation. With a scenario-based approach, this is all prenegotiated and can be implemented in a fraction of the time, before its efficacy has faded and conditions become even worse.

You will have noticed the absence of mention of a plan C or plan D. These represent the more extreme adverse and severe scenarios, already being evaluated during annual supervised stress-testing exercises. These are non-adjacent scenarios representing a significant discontinuity in the market, such as a recession or a major counterparty crisis. While you should have contingency plans in place for them as well, they do not constitute the bulk of ongoing peacetime business decision-making.

While innovation will remain a key driver of growth and profitability, it must be innovation at speed. Remaining competitive, let alone thriving, becomes a matter of execution and agility. To reiterate an earlier point, the most valuable aspect of being a scenario-driven enterprise is the speed at which you can act when circumstances dictate. Once you’ve determined you’ve crossed a threshold, having the appropriate precooked, pretested, non-negotiable plan B ready is the best approach to better outcomes through decision-making and execution at speed: better decisions, faster.

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