Reverse Stress Testing

Reverse Stress Testing

What is Reverse Stress Testing?

Reverse stress testing works backward from a defined failure point to identify scenarios that could cause that outcome. Unlike traditional stress testing, which asks "what happens if?", reverse stress testing asks "what would cause failure?"

Regulatory Context

• UK PRA requirement
• EBA stress testing guidelines
• Basel recovery planning
• ICAAP/ORSA requirements

Failure Points

Business Model Failure

• Loss of key revenue sources
• Loss of critical capabilities
• Uncompetitive market position

Financial Failure

• Breach of regulatory capital
• Inability to fund operations
• Loss of market access

Operational Failure

• Critical system failure
• Key person dependency
• Supply chain disruption

Reputational Failure

• Loss of customer confidence
• Regulatory action
• Market exclusion

Methodology

Step 1: Define Failure Points

• Quantitative thresholds
• Qualitative conditions
• Point of non-viability

Step 2: Identify Vulnerabilities

• Key dependencies
• Concentration risks
• Single points of failure
• Interconnected risks

Step 3: Develop Scenarios

Work backward to identify:

• What events could cause failure?
• What combinations of events?
• What sequence of events?

Step 4: Assess Plausibility

• Historical precedent
• Expert judgment
• Market conditions
• Emerging risks

Step 5: Quantify Paths

• Loss magnitude
• Speed of deterioration
• Feedback loops
• Contagion effects

Step 6: Develop Mitigants

• Early warning indicators
• Preventive measures
• Contingency plans
• Recovery options

Scenario Categories

Single Event Scenarios

• Major fraud
• Cyber attack
• Key counterparty failure
• Regulatory prohibition

Combination Scenarios

• Market + credit + operational
• Economic + regulatory + reputational
• Multi-factor cascading events

Governance and Use

Board Involvement

• Review and challenge
• Strategic implications
• Risk appetite linkage

Integration

• Recovery planning
• Strategic planning
• Risk appetite setting
• Capital planning

Documentation

• Scenario descriptions
• Failure pathways
• Plausibility assessment
• Mitigation measures
• Action triggers

Best Practices

• Regular refresh
• Creative scenario development
• Cross-functional involvement
• Challenge sessions
• Action-oriented outcomes
• Clear ownership