Coming out of the financial crisis the banking industry has found itself under scrutiny with regards to its resilience and questions have been raised about financial institutions’ abilities to weather another storm. How good are your preparations in reality?

If you want to know what shape your crisis readiness is really in, you need to start by re-appraising your stress testing framework. The objective is to prepare for potentially disastrous conditions in advance – instead of picking up the pieces afterwards.

Presently the industry is seeing a flurry of controversy around stress testing and its outcomes. If the banks pass the test, the cry immediately goes up from some quarters that they are too easy. The situation is compounded by ever-increasing rigor and frequency of testing, with the European Banking Association’s 2013 planned schedule being a prime example.

Should an institution fail, the inevitable dangers include crisis of confidence and reputational damage. In a land of (presumably) unintended consequences, there is a risk that banks could suffer almost as much in the ‘wind tunnel’ of stress testing as they might in a genuine external crisis!

The only viable solution is to develop as much detailed knowledge as possible, about likely impact on the organisation and its response to stress patterns that are as realistic and ‘granular’ as any theoretical exercise can ever be. This means developing a state-of-the-art stress testing framework – which is key to the ability to:

1.            Properly apply stress scenarios and measure their impact on an institution’s balance sheet and;

 2.            Provide sufficient management insights to inform and drive effective actions.

A self-contained analytical process which quickly assesses the in-place stress testing framework and then cross-compares it with current industry best practice is a must. Any offering should aim to assess the way institutions identify and calculate what can happen to the balance sheet and income statement in a ‘perfect storm’, i.e. a severely adverse scenario. The whole surrounding process should be considered, including data management, modelling techniques and, crucially, what management does with any stress test output information and how well prepared they are to take appropriate action.

Do you have a view on the validity of stress testing or current industry approaches to ‘perfect storm’ preparation? Join in the discussion.