Reverse Stress Testing: Linking Risks, Earnings, Capital and Liquidity – A Process-Orientated Framework and Its Application to Asset–Liability Management

Michael Eichhorn, Philippe Mangold

Reverse stress testing (RST) is commonly understood to be the identification of adverse scenarios that render the business model unviable. Prior to the 2007–9 global financial crisis, few, if any, banks worked on RST. After the financial crisis, regulators and de facto regulatory bodies introduced different requirements and recommendations for banks to perform RST. EY (2013), in a survey of major international financial institutions, noted that the importance of RST as a tool for risk measurement and risk management strongly increased. However, there is still neither detailed regulatory guidance nor an industry standard or “best practice” on how to implement RST in a meaningful way.

While both traditional stress testing and RST involve the analysis of adverse scenarios and their respective impacts, they differ in two key aspects.

  • 1.

    Direction: in traditional stress tests, banks start by defining a scenario specifying adverse macroeconomic or financial conditions (or a combination thereof). Banks then assess the impact on their business, typically in terms of earnings, and capital and liquidity adequacy, over a specific period of time. Conversely, RST starts by defining the

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