The Financial Services Authority (FSA) has strengthened its stress testing regime by requiring firms to improve their stress testing capability, enhance their capital planning stress testing and by introducing a reverse stress testing requirement for firms.

The FSA’s integrated approach to stress testing consists of three main elements:

• Firms' own stress testing – The FSA expects firms to develop, implement and action a robust and effective stress testing programme which assesses their ability to meet capital and liquidity requirements in stressed conditions, as a key component of effective risk management
• FSA stress testing of specific firms – As part of its more intrusive supervisory approach the FSA runs its own stress tests on a periodic basis for a number of firms. This is carried out regularly for specific high impact firms and for other firms as the need arises, to assess their ability to meet minimum specified capital levels throughout a stress period.
• Simultaneous system-wide stress testing – This is undertaken by firms using a common scenario for the purposes of specific system-wide analysis for financial stability purposes.

The FSA is taking steps now to strengthen all elements of its stress testing approach although the changes mentioned in this policy statement refer to firms’ own stress testing.

Paul Sharma, FSA director of prudential policy, said:

"Stress and scenario testing should be an important element in firms’ planning and risk management processes. These changes send a clear signal to firms’ senior management that they need to engage in building a robust stress testing infrastructure as an important part of effective risk management, and use that to assess capital needs in a stress.

"Reverse stress testing is a separate, but complementary exercise. It is essential that firms identify what could cause their business to fail and use this information to ensure that the relevant risks are sufficiently well-understood and appropriately managed to secure consumer protection and market confidence.”

Next steps

The FSA will be recommending scenarios to help firms improve capital planning in 2010.

Reverse stress testing will sit alongside the current range of stress tests that firms are required to carry out to ensure that firms identify and assess scenarios most likely to cause their current business models to become unviable.

Firms subject to the new reverse stress testing requirement will have 12 months to incorporate reverse stress testing into their current suite of stress tests and risk management tools.

Capital Planning Buffers

Alongside today’s policy statement, the FSA published a short consultation paper clarifying its approach to capital planning buffers (CPB). The CPB is the amount of capital that a firm should hold now so that it is available to absorb losses and meet higher capital requirements in adverse external circumstances such as an economic downturn.

The FSA is consulting on simplifying its approach and has provided further clarity about expectations on the use of the CPB and the mechanism by which firms can draw down the buffer.  This is an initial step in improving firm’s capital ahead of international discussions which will take place in 2010.

The consultation period closes on 31 March 2010.

Notes for editors

1. Consultation paper 09/30.
2. Policy Statement 09/20.
3. Details on the FSA’s integrated approach to stress testing can be found in Annex 6.
4. The FSA has previously published the following in relation to stress testing and relevant capital ratios: 
   FSA Statement on Capital Approach Utilised in UK Bank Recapitalisation Package
   FSA Statement on regulatory approach to bank capital
5. The FSA regulates the financial services industry and has four objectives under the Financial Services and Markets Act 2000: maintaining market confidence; promoting public understanding of the financial system; securing the appropriate degree of protection for consumers; and fighting financial crime.