Stress Testing in a Risk Management Program
Today, many organizations are performing stress tests as a part of their Enterprise Risk Management program. What is a stress test? How will it benefit my organization?
Stress testing evaluates the potential impact on a company’s balance sheet for a specific event and/or movement in a set of financial variables. It can be an effective risk management tool. Many risk managers agree that stress testing should be an enterprise wide function that accounts for views from across the organization covering a range of perspectives and techniques.
Two effective methods to perform stress testing include sensitivity and scenario analyses. Sensitivity analysis can be useful for a range of purposes, such as testing the robustness of the results of a model or system in the presence of uncertainty. For example, what effect would a 10% decline in the stock market index have on the balance sheet? Future tax, interest, and inflation rates, operating expenses and other variables may not be known, so a sensitivity analysis can assist managers to answer the question, "what will be the effect on the business operations, and what variables are causing it?"
Scenario analysis differs from sensitivity testing in that it analyzes a situation and provides high, medium, and low scenarios based on the given inputs. It allows managers to explore different ‘what ifs’ and helps them to make better decisions. Scenario analysis can be thought of as performing multiple sensitivity analyses at the same time. Normally the scenario with the most likely outcome should be used in order to develop a risk mitigation strategy.
Managers throughout the organization should identify their areas of concern and design meaningful stress test analyses with a set of appropriate risk factors. The results should be realistic and appropriate. The next step is the adoption of a risk mitigation/contingency strategy for each risk identified, based on the outcome of the impact analysis, with a focus to lessen the impact of a particular threat.
After developing the risk mitigation strategies, managers are ready to present their reports to upper management. Many organizations find that these discussions are very useful. The findings can help identify high concentrations of risk that may not have been previously transparent.
Stress testing should be an integral part of a Company’s overall governance and risk management culture. A good set of stress tests enables managers to proactively reduce unacceptable risk levels by identifying structured decision-making for possible risk exposures.