FSA plans reverse stress tests

According to the Financial Services Authority, stress testing at UK financial firms is too weak to prevent another Northern Rock crisis. It recommends firms perform "reverse stress tests" to identify high-risk scenarios.

In a consultation paper published yesterday, the FSA said UK firms were still not testing themselves against sufficiently severe scenarios.

"For example, the holding period and the duration of the stress are often very short and take little account of the possibility of extended periods of market disruption such as conditions witnessed over the past year. Furthermore, the implementation of these stress tests fails to take into consideration the correlations and co-dependencies of the firms' risks and positions beyond those in their trading books," the FSA said, adding most firms "have not yet gone so far as to significantly challenge their underlying business models".

Furthermore, managers might have been unwilling to prepare for severe events because of moral hazard. "They felt they could actively manage these [moderate] events while public authorities would step in during market-wide, severe scenarios," noted the FSA.

In a reverse stress test, firms would be expected to identify scenarios that could threaten their survival and describe the precautions they were taking against them. Survival could be threatened by a general loss of market confidence, even if the firm still had adequate regulatory capital, the FSA added.

The authority plans to bring out a discussion paper on reform of prudential requirements in the first quarter of 2009.

See also: FSA to order banks to stock up on Treasuries
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