Stress testing of banks: an introduction
Types of banking stress test
There are two types of banking stress test:
- We run an annual stress test of the largest UK banks and building societies. This informs policymaking by our Financial Policy Committee and the Prudential Regulation Authority (PRA).
- Firms that are not part of this annual stress test must carry out their own stress testing. The PRA publishes a scenario every six months to serve as a guide for banks and building societies designing their own scenarios.
Annual banking stress test
We published the 2018 annual stress test scenario and guidance for the seven largest banks and building societies on 16 March 2018.
The results of the 2017 stress test of the UK banking system were published on 28 November 2017.
Key elements of the 2018 stress test
Variable paths for the 2018 stress test
Traded risk scenario for the 2018 stress test
2018 stress guidance for banks and building societies
Stress testing the UK banking system: 2017 results
Scenarios for banks and building societies not part of concurrent stress testing
Starting in March 2018, the PRA will publish two stress test scenarios for use by banks and building societies that are not part of the annual concurrent stress testing exercise.
These scenarios will be published together annually. They are a guide and, where relevant, a benchmark of severity for firms designing their own scenarios. By publishing two differing scenarios, our aim is to encourage firms to consider the type, characteristics and severity of stress that their business model is vulnerable to, when designing their own stress testing scenario (or scenarios).
We published our most recent single scenario on Friday 21 April 2017. It’s here:
2017 H1 stress scenario
The results of stress tests are an important consideration for when we decide how to set capital requirements for banks and building societies.
You can find guidance on the role of stress testing within the framework for setting banks’ capital requirements in our Supervisory Statement on the internal capital adequacy assessment process (ICAAP) and the supervisory review and evaluation process (SREP). It’s here:
Supervisory Statement 31/15
How our stress tests should be used
You should consider the stress test scenarios in the context of your business and its own specific risk drivers. Our scenarios should be used as a starting point to build and accurately measure your own scenario under Pillar 2. We know any single scenario that is designed for firms with very different business models and risks, has its limits. We expect you to choose a scenario that provides a strong challenge for your business.
You are ultimately responsible for developing your own scenarios to test your firms’ resilience. Large banks and building societies should use the annual cyclical scenario.
Firms who are subject to IFRS 9 should consider the following clarifications covering the expected approach to IFRS 9 within ICAAPs.
Clarification on IFRS 9 for 2017 ICAAP stress testing and capital planning
Clarification on IFRS 9 for 2018 ICAAP stress testing and capital planning
Stress testing: insurers
Insurance firms use stress and scenario testing to consider the potential impact of certain adverse circumstances on their business. It is an important element in firms’ planning and risk management processes, helping them to identify, analyse and manage risks.
Insurers should develop, implement and action a robust and effective stress testing programme that assesses their ability to meet capital and liquidity requirements in stressed conditions, as a key component of effective risk management. All firms should undertake relevant analysis, commensurate with the nature, scale and complexity of their business.
The Prudential Regulation Authority (PRA) also runs its own stress tests on a periodic basis for a number of insurance firms. It does this 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.
System-wide stress testing is also undertaken by firms using a common scenario for financial stability purposes. To support its framework, the PRA sets policy for firms' stress testing requirements, sets stress scenarios and monitors test results.
Reverse stress tests
The PRA also expects insurance firms to apply reverse stress testing as part of their own risk and solvency assessment (ORSA) process. Reverse stress tests are stress tests that require a firm to assess scenarios and circumstances that would render its business model unviable, thereby identifying potential business vulnerabilities. This differs from typical stress and scenario testing, which tests for outcomes arising from changes in circumstances. A firm's business model is described as being unviable at the point when crystallising risks cause the market to lose confidence in the firm.
Reverse stress testing is primarily designed to be a risk management tool, encouraging firms to explore more fully the vulnerabilities and fault lines in its business model, including 'tail risks', and to explore potential mitigating actions. The PRA works with counterparts in the EU and internationally on approaches to stress testing.
Supervisory Statement 19/16
Insurers: using the bank stress test scenario
The 2017 banking stress test scenario aims to give firms a consistent basis on which to confirm that their planned capital resources are sufficient to remain solvent and adequately capitalised in order to continue to write business throughout the capital-planning horizon (normally three to five years).
Banking system stress testing scenario: 2017 H1
Firms may consider the conditions implied by the parameters set out in the scenario in order to derive consistent assumptions, on a prudent basis, for key risk factors that would affect their projected capital requirements. Firms should also consider insurance risk aspects (e.g. recession-related claims) arising from the scenario.
Insurers may incorporate these assumptions into their capital planning processes, and be prepared to show this in discussions with their supervisors. Insurers should also examine the complementary relationship between the one-in-200-year required stress and the macroeconomic scenario used for capital planning purposes. For example, a four-year capital plan might assess how a firm expects to be able to continue to meet its capital requirements over the next few years in the face of a changing economic environment.