Testing for testing times

In the aftermath of the Financial Crisis, authorities developed regimes which provide the tools to deal with failing financial institutions in an orderly manner without the need to revert to taxpayer bail-outs. Global regulators’ resolution frameworks now place overall accountability on firms to own their resolvability and require established and tested capabilities to be in place to support authorities’ actions in a crisis.

Recent events, namely the failure of several regional US banks and the merger of Credit Suisse with UBS, have placed recovery and resolution planning firmly back under the microscope. Failures of financial institutions do happen, and firms and authorities have an obligation to be prepared. It has reinforced the clear public interest in continuing to refine, enhance and test the robustness and effectiveness of these capabilities and this has been reflected in recent speeches and publications by the Bank of England (“BoE”), Single Resolution Board (“SRB”) and Financial Stability Board (“FSB”).

It is not job done...

Dave Ramsden’s recent speech on resolution planning focused on three key pillars i) Operational Readiness; ii) Enhancing Readiness; and iii) Ensuring Resolvability.

With initial compliance deadlines having mostly passed and the first rounds of public disclosures having been published, Dave Ramsden’s speech made clear this is certainly not job done from a firm and authority perspective.

“…focus more on testing and exercising going forward...”

(Dave Ramsden: The Weekend Starts Here Speech)

A key tool in demonstrating ongoing readiness...

A mature Recovery and Resolution Planning programme should place high importance on regular and long-term testing and assurance plans.

Key benefits include:

• Assessing actual practical effectiveness and executability of plans and capabilities to allow firms to identify and remediate weaknesses in preparations
• Building muscle memory in the firm to support execution of roles and responsibilities in a crisis scenario
• Providing comfort to senior management and authorities that capabilities in place are fit for purpose

It is imperative to note that testing and assurance is not viewed as “pass or fail” exercises. Instead, it should be viewed as a continuous learning process to support the ongoing maintenance and enhancement of recovery and resolution capabilities. Whilst firms should incorporate leanings from other forms of testing across initiatives such as business continuity and stress testing, it is essential to build on them and incorporate the specific challenges and roles and responsibilities in a resolution.

At a high level, we see three broad “types” of testing for firms to incorporate into their programmes.

1. Barrier level... regular testing at a barrier level is an important tool to allow barrier owners and accountable executives to get comfortable with work done to implement recovery and resolution capabilities and support the sign off of playbooks, self-assessment, public disclosures, or other regulatory documents.
2. Outcome testing... testing should also be undertaken looking at the interlinkages and handoffs across different barriers working in conjunction, as will be the case of a resolution scenario to deliver desired outcomes. This can support the embedding of resolution capabilities in Business as Usual (BAU), as resolution capabilities should be integrated into existing frameworks and controls to support ownership and maintenance.
3. Senior Management and Board Exercises… as a firm nears a crisis, it is expected Senior Management and the Board will take more active involvement in guiding the firm through. Therefore, it is essential that programmes incorporate exercises which enhance, and test understanding of roles and responsibilities and validate the outputs and MI upon which they will make decisions on the basis of. A further benefit is demonstration of regular engagement and oversight of arrangements to the regulator.

Key considerations designing a framework…

A multi-year testing and assurance programme should incorporate a level of testing across these three key pillars. Based on our extensive experience of supporting international authorities and multiple firms, the regularity and granularity of testing should vary by year and by each firms’ business model, size, and risk exposure. When deciding which areas to prioritise testing on, there are several factors which could be incorporated:

• Regulatory Priorities: priority areas of the regulator should be factored in to ensure well positioned for future engagement. For example, the BoE has outlined a focus on Financial Barriers in the first RAF cycle, moving to Continuity and Restructuring as part of the upcoming second RAF cycle.
• BAU Benefit: to consider testing and enhancing areas which may add value in BAU. For example, designing a restructuring exercise which enhances recovery capability and BAU strategic restructuring opportunities.
• Market Events: it is important to factor in recent events given they will likely inform the focus areas of regulators and senior management. For example, considering the events of 2023, there should be consideration of Funding in Resolution (“FiR”) given the speed of outflow and on Communications given the likely role social media played in deteriorating a situation further.
• Operationalisation: another key factor to take into account when designing testing regimes is the shift in focus towards the operationalisation of capabilities, with a focus on the actual execution and practical use of capabilities vs a focus on demonstrating compliance against a set of regulations.
• Role of 3LoD: it is important 2nd and 3rd line engagement and reviews compliment testing and assurance frameworks.
• 3rd Party Support: firms should consider proportionate and relevant use of 3rd party support. This can allow firms to leverage practical skills, industry insight and experiences which do not sit in house.

It is important that underpinning it all, firms develop something which is proportionate and appropriate. A proportional approach which considers competing priorities and focuses on execution of capabilities rather than a tick box compliance exercise.

Outcome testing…

Operational testing is critical to ensure that relevant capabilities are in place to allow firms to operationally execute their resolution strategy. Testing should not only focus on the required capabilities to support execution of a firms’ preferred resolution strategy, but should also consider scenarios where optionality or an alternative resolution strategy may best meet resolution objectives.

Given the central role it plays in a resolution scenario, including the number of interlinkages across multiple barriers, a restructuring test is a key exercise we are seeing firms consider. For example, considering testing the ability to implement, maintain and exit TSAs. Another example of these types of exercises would be a communications exercise which could focus on a firms’ ability to develop communications, monitor social media, and maintain the operational capability to send out the level of communications required in a resolution scenario.

Given the uncertain nature of events that would lead a firm to resolution, these tests should have some flexibility, as in reality it would be nearly impossible to simulate an exact scenario of what would happen. Therefore, a key aim of these exercises is to show that firms can respond to difficult situations with the frameworks and capabilities in place.

Senior management exercises…

Most firms have completed initial educational “Briefing” exercises with senior management to give a core understanding of resolution, the firms’ strategy and likely roles and responsibilities. The focus and expectation of regulators is now shifting to more complex simulation style exercises.

Firms should consider leveraging existing materials such as Master Resolution Playbooks (“MRP”) and operational documentation when designing exercises. The design of the Senior Management exercises will both influence the benefits received as well as the level of resource required in preparation. Conducting an exercise with Senior Management is a significant undertaking requiring a material level of preparation time with key design decisions including:

Testing... the regulator is banking on it…

The overarching objective of testing is to enhance preparations of a firm and its staff in tackling a crisis scenario. Therefore, following the completion of testing cycles and significant exercises, it is essential firms document outcomes, learnings, and next steps.

In conclusion, recent events have further highlighted the need for a robust testing and assurance process. Sam Woods highlighted this in his recent speech noting "...there is still a lot of work to be done to improve and refine the regulatory regime for [bank failures] ...”.

Testing and assurance of recovery and resolution capabilities plays a key role in improving resolvability and increased financial stability.