New Year’s Resolution: Stress Test Your Business Model
In some industries, stress testing is now mandated and is becoming formalized. In 2012 the Federal Reserve Board is requiring 31 U.S. bank holding companies with assets of more than $50 billion to submit capital plans and undergo stress testing under Comprehensive Capital Analysis and Review (CCAR). Solvency II has formalized the reporting of stress tests and reverse stress tests by insurance firms.
The concept of stress testing applies to all business, not just to those that have been mandated by the government. In the past decade, businesses have become increasingly vulnerable to disruption by outside events. External threats ranging from macroeconomic malaise to terrorism, cyber crime, computer viruses, market shocks, political instability, and regulatory restrictions, as well as consumer activism and social media hype are just of few of the things that can have grave impacts on a business’ operations, profitability and reputation.
As a result, stress testing and scenario analysis are becoming critical components of risk management and business continuity planning, especially for financial institutions and insurance carriers as well as virtually all multi-nationals and public companies. Stress testing provides management and other stakeholders with information necessary to assess a firm’s resilience in the face of adverse conditions caused by internal and/or external events and take steps to mitigate the risks or at least minimize the adverse impact on business operations.
There is no universal methodology or simple formula for stress testing and scenario analysis. The risk factors vary depending on a firm’s organization, size, markets, operations, supply chain, global reach, employee base, etc. Every organization must develop its own rubric, scenarios and plans for stress testing and then implement continuity plans that are consistent with the potential risks and the scope and scale of their operations.
It is a daunting task – and one that’s all too easy to put off until mañana. Unfortunately, in today’s business and economic climate, that is not possible. Stress testing is an imperative.
A way to begin defining the stressors to test is to think about the things that keep you awake at night. Besides active threats, these may include a rise in interest rates, a precipitous drop in demand for your products or services, a competitor’s aggressive pricing strategy, a market trend that you missed out on, or a myriad of other things.
Once you have a list of nightmare scenarios, you can play them out and consider how they might impact your business model. In particular, look at the capital implications and assess your firm’s capital adequacy under stress scenarios using customary profitability, solvency and efficiency ratios. Push hard. If you find that the results don’t affect your business model, your stresses probably aren’t strong enough.
The point at which the capital and/or liquidity of the firm is exhausted is one point where your business model could fail. But there are also many non-financial aspects that could make your business unviable, and you need to look at the whole picture. Reputational risk, market risk and technological risk could potentially stress your firm to the breaking point as well.
Play out the possible consequences of each identified stressor from all perspectives. Involve C-level representatives from finance, IT, marketing, communications, operations, HR, procurement/supply chain and customer service.
Once embedded into the organization’s risk culture, stress testing and scenario analysis will give you greater confidence in your firm’s business model and ability to withstand disruptions – and once again allow you to sleep peacefully. Make it a resolution to integrate stress testing into your business plan in 2012.