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Is your stress testing and risk appetite framework adding value to your business?

Almost 18 months after the implementation of the Investment Firms Prudential Regime (IFPR) by the Financial Conduct Authority (FCA), stress testing arrangements and risk appetite frameworks are key focus areas for the regulator across the market. We will cover some key stress testing and risk appetite considerations below. In addition some general IFPR observations can also be found in our previous Risk Advisory IM&W blog.

Stress testing process

Building on previous expectations set out in Finalised Guidance 20/1, under the IFPR the FCA expects investment firms to conduct stress testing to help demonstrate the adequacy of financial resources and to demonstrate ongoing compliance with the Overall Financial Adequacy Rule (OFAR). Stress testing represents a key tool through which firms assess whether they hold sufficient levels of own funds and liquid assets to achieve their planned business strategy, throughout the economic cycle, mitigating harms that could arise under different forms of stress.

We have highlighted below some key weaknesses in stress testing processes which we have identified though engagements with clients, industry interactions and recent FCA feedback:

  • Scenario selection: There is a disconnect at some firms between the business strategy assessment, the risk identification process and how stress scenarios are selected and calibrated. This disconnect can lead to stress testing that does not cover all of the firm’s relevant key risks. This, in turn, may mean that management does not have full visibility of the harms that could occur in a stress, restricting the firm’s ability to take measures to mitigate these harms proactively. For example, we have observed firms failing to consider appropriately key strategic initiatives (such as business growth or a material new product) within their stress testing. Alternatively, we have observed firms using banking stress scenarios set by the Prudential Regulation Authority that may not pick up risks specific to the business model and risk profile of the investment firm.
  • Severity calibration: Calibration of stress tests that are sufficiently severe is another area of weakness that we have observed. This has been a frequent point raised by the FCA in recent Supervisory Review and Evaluation Process (SREP) feedback letters to firms and in their market feedback. For example, some firms have not considered the impact of multiple stresses (simultaneously) but instead applied certain stresses to elements of their business model in silos and then aggregated the results. This approach may not show the full collective impact (from a financial or harms perspective) of multiple facets of stress on the business. Inappropriately calibrated stress scenarios and a lack of consideration of the potential for stresses to occur simultaneously could hinder a firm’s ability to demonstrate compliance with the OFAR on a forward-looking basis.
  • Use of models: Where complex models have been used in a firm’s stress testing, the key modelling assumptions and potential limitations have not always been understood to a sufficient degree by all members of the management team. A lack of understanding and oversight from Executive/Board members in this area may result in a less robust process for the challenge and validation of key inputs and outputs.
  • Liquidity stress testing: The Internal Capital Adequacy and Risk Assessment (ICARA) process covers both own funds and liquidity assessments and liquidity stress tests should, therefore, be considered when setting the Liquid Asset Threshold Requirement (LATR). In many cases firms do not carry out adequate liquidity risk identification and assessment. For example, general business model stress scenarios have been used by some firms and these may not be appropriate in the context of calculating the LATR. This could result in key sources of liquidity risk and stress not being considered sufficiently, undermining the firm’s ability to demonstrate compliance with the LATR on a forward-looking basis.
  • Documentation quality: In some cases, the documentation associated with firms’ stress testing (in particular the articulation in the ICARA document) has failed to demonstrate the completeness of the scenario selection process and the appropriateness of key assumptions within each scenario. Documentation weaknesses can undermine the quality and robustness of a firm’s stress testing process.

Effective forward-looking stress testing can provide a useful understanding of areas of vulnerability under stress, during which risks and potential harms may increase. This provides management with critical information on areas in which risk management capabilities and financial resources of the investment firm may no longer be commensurate with the potential harms in a stress event. The stress testing process should therefore be used as a tool, among other things, to:

  • Assess and validate key business and strategic decisions;
  • Support the development and ongoing enhancement of a firm’s risk appetite framework;
  • Determine the appropriate calibration of risk appetite metrics, monitoring thresholds and intervention points in order to identify, monitor and manage risks and harms effectively;
  • Monitor the adequacy of financial resources and compliance with the OFAR on an ongoing basis; and
  • Develop appropriate wind-down scenarios and triggers.

Risk appetite framework

In the FCA’s recently published IFPR implementation observations, one area that was highlighted is that many firms lack comprehensive processes to determine own funds and liquid assets triggers and limits. Firms have been criticised by the FCA through SREP feedback for the limited ways in which their stress testing outputs are embedded within the wider risk management framework, with internal indicators and limits set at arbitrary levels that do not consider the impact of a stress event on the firm’s capital and/or liquidity adequacy.

Firms should consider whether their risk appetite frameworks require enhancements in order to meet the FCA’s expectations. In particular, below are some of the key issues we have observed:

  • The process for setting capital and liquidity risk appetite, thresholds and metrics is not sufficiently mature at some firms. For example, a number of firms are using the FCA’s notification triggers (such as, 110% of the Own Funds Threshold Requirement (OFTR)) as their internal risk appetite limit without sufficient supporting rationale to demonstrate the appropriateness of these levels for their business model and risk profile. If risk appetite metrics are set too low, these indicators will not allow sufficient time for management to implement remediation actions to restore capital or liquidity resources prior to regulatory minima being breached. In the absence of consideration of stress testing outputs in the calibration of these indicators or triggers, firms may not have sufficient visibility of whether the levels at which they are set will provide sufficient warning to allow for effective action to be taken.
  • Additionally, risk appetite thresholds and metrics have sometimes been articulated at group level without consideration of the risk profile of individual entities. For example, firms setting risk appetite at an investment firm group level have not always considered the level of own funds or liquid assets that would be required at an individual entity level. Alternatively, we have observed some firms using the same trigger for both capital and liquidity (despite their different purposes and risk profile) without sufficient justification or explanation.
  • In certain instances, it has not been clear whether all the material drivers of risk have been considered when setting risk appetite and monitoring metrics. This can be caused by a lack of consideration of relevant stress scenarios and could lead to an inappropriate calibration of risk appetite.
  • Risk appetite metrics and monitoring frameworks have often not considered sufficiently the financial resources that would be required to support an orderly wind-down. Given that the OFTR and LATR require consideration of on-going as well as wind-down requirements, it is important for on-going and wind-down assessments to be considered when setting and monitoring risk appetite. Indeed, where the OFTR or LATR is driven by the wind-down requirement, some firms’ risk appetite monitoring metrics and tiggers have not been calibrated appropriately to ensure there is sufficient time for management to identify adverse trends and take action (as also noted in the FCA’s Thematic Review 22/1). Where insufficient consideration has been given to the wind-down requirement, there is a risk that a firm would take too long before taking action and this could lead to a disorderly wind-down.
  • The FCA also observed that there was a significant lack of clarity at some firms regarding actions that would be taken at each level of monitoring metric or trigger. For example, some firms have not documented clearly whether the breach of certain metrics would lead to discussions relating to potential actions or would automatically trigger remediation actions. This lack of clarity could undermine the overall effectiveness of a firm’s risk appetite framework.

What are the key actions for firms to consider?

Stress testing and risk appetite are critical risk management tools, providing firms with a forward-looking view of the potential harms that may arise as a result of their operations, as well as their risk capacity and tolerance. Firms should be challenging themselves to assess whether stress tests are sufficiently severe and have been leveraged when setting risk appetite limits.

In particular, firms should consider whether their processes to set business strategy, identify key risks, select stress scenarios and calibrate risk appetite metrics are joined up consistently (and documented clearly through the ICARA process). Ensuring alignment between these processes will strengthen the effectiveness of the risk management framework, helping to provide sufficient time and information for management to identify and correct adverse trends at an early stage before potential risks crystalise.

Should you have any queries, or would like to attend Deloitte IFPR industry roundtables, please contact any author of this blog.