Reverse Stress Testing

Definition

Reverse Stress Testing is a type of Stress Testing which starts from the identification of a pre-defined outcome (e.g. an economic / financial state at which a business model becomes non-viable, or at which the firm an be considered as failing or likely to fail) and then explores scenarios and circumstances that might cause this to occur. This is in contrast with "regular" or forward stress testing that starts with the identification of a set of scenarios and explores their ultimate outcome.

Characteristics of Reverse Stress Testing

Reverse stress testing has the following characteristics:

• It is used as a risk management tool aimed at increasing the institution’s awareness of its vulnerabilities by means of the institution explicitly identifying and assessing the scenarios (or combination of scenarios) that result in a pre-defined outcome
• the institution estimates the likelihood of these scenarios occurring
• the institution decides on the kind and timing (triggering events) of management or other actions necessary both for rectifying business failures or of other problems and for aligning its risk appetite with the actual risks revealed by the reverse stress testing
• specific reverse stress testing can be also applied in the context of recovery planning

Relationship with Economic Capital

Reverse Stress Testing has strong overlap with the Economic Capital concept. The primary difference is that Economic Capital frameworks were developed as internal tools by firms, whereas reverse stress testing came to prominence as a regulatory requirement post-crisis

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