In an increasingly volatile and uncertain financial landscape, understanding the limits of a business model is a strategic necessity. Reverse stress testing (RST) is a powerful risk management tool that allows businesses to identify the scenarios under which their business model would fail, exposing weaknesses that may not be visible through conventional stress testing.

RST challenges firms to confront potential fragilities, rethink assumptions, and prepare robust contingency plans. This Audit and Assurance Faculty guidance aims to help practitioners, particularly those working in industry, to support their organisations’ strategies.

Why undertake reverse stress testing?

Performing a reverse stress test has already been mandated for many businesses in the financial services sector by the Financial Conduct Authority (FCA). The purpose of performing an RST is defined by the FCA as being to “provide useful information about vulnerabilities in a firm’s business model and strategy” (FG20/1). Bearing this in mind may be helpful when designing measures to prevent and mitigate the risk of business failure. 

Crucially, RST should not be viewed as a tick-box exercise to reassure businesses and their auditors that their models and forecasts have sufficient headroom to support the going concern assessment. The objective of RST is to find, rather than hide, weaknesses and vulnerabilities as part of effective risk management.

RST vs stress testing

It is important to clearly define the meaning of “reverse” within the phrase “reverse stress testing” to differentiate the procedure from other types of stress testing.

The process for performing a reverse stress test differs in key ways from conventional stress testing, which are important for businesses carrying out RSTs to understand.

Stress testing

Stress testing is a forward-looking analysis technique often used to support a business’s going concern assessment over a 12-month period. An entity identifies a range of adverse scenarios of varying nature, severity and duration relevant to its business, and considers its exposure to those scenarios.

Stress tests involve a variety of techniques, including sensitivity analysis, and can be carried out on individual activities as well as at entity-wide level.

Stress testing typically involves shifting the values of individual parameters that affect the financial position or performance of an entity and then determining the impact on the entity’s financial resources. This allows mitigating actions to be developed.

Stress testing can be used to:

• quantify to what extent reserves might be absorbed, or cash required, if an adverse event occurs;
• provide a check on the outputs and accuracy of risk models; and
• explore the sensitivities in business plans and how capital needs might change over time.

Reverse stress testing

In contrast, a reverse stress test starts from the opposite end – with the identification of a pre-defined outcome. This outcome could be defined as the point at which the entity’s business plan becomes unviable.

Unlike conventional stress testing which might adjust one parameter at a time, a reverse stress test could consider combinations of adverse circumstances that might cause the failure of the business.

RST is a systematic process of finding weaknesses in a business and deciding on the action that needs to be taken.

Defining ‘unviability’

Before commencing an RST exercise, a business must define the outcome. This could be the point at which the company’s business plan becomes unviable. That said businesses must still consider what “unviability” means for them, as different companies are likely to have different definitions.

Unviability is not likely to be represented by a single quantifiable financial threshold being reached, such as the company becoming technically insolvent. For example, in many businesses, a collapse in market confidence would be likely to render the business plan unviable long before the point of technical unviability in purely financial terms.

Simply flexing existing assumptions, as in conventional stress testing, to reach the point at which a forecast model “breaks” is not sufficient for a reverse stress test.

A company may, therefore, come up with multiple plausible definitions of what business failure would look like for them. If this is the case, then it may be necessary to perform more than one RST to explore the circumstances that could lead to each one.

Timeframes for ‘unviability’

RST is a risk management tool, it is not narrowly focussed on proving that an entity is a going concern.

Companies should consider what risks have the potential to emerge in the future that could disrupt their business plan, rather than just considering risks that exist currently as one might when performing a scenario test or sensitivity analysis.

An RST should be designed to find weaknesses and vulnerabilities that management may not previously have considered, so that appropriate mitigating action can be put in place.

Businesses will want to be clear about the timeframe that they are looking at before commencing the RST to understand what mitigating actions would be appropriate. For example, if a potential vulnerability identified through the test is likely to emerge over a long period of time, monitoring the situation may be sufficient mitigation rather than intervening more proactively.

Combination of adverse circumstances

An RST could consider combinations of adverse circumstances that could cause the failure of the business. Looking at multiple possible eventualities, and considering how they might intersect, adds further complexity to the exercise and may raise further questions for those performing the RST.

For example, it can be difficult to determine how severe the circumstances under consideration should be while retaining plausibility. Scenarios which are too outlandish are unlikely to generate useful information on a company’s weaknesses and vulnerabilities and, therefore, can’t be used to effectively evaluate risk or determine appropriately targeted mitigating actions.

Using a combination of less severe adverse circumstances which aggregate to the same final outcome of business failure may provide a more reasonable basis for appropriate risk identification and management.

It may also be challenging for businesses to consider how to factor in second- and third-order effects when dealing with multiple variables. Different circumstances under consideration will interact with each other in combination which could produce further impacts for the business. It is important for the RST to take these potential interactions into account rather than only considering the direct impacts of each adverse circumstance being used.

Similarly, the RST should also factor in the potential actions of other market participants and consider how this could affect their business. For example, if one of the adverse circumstances under consideration involves market stress in some form, it may not be realistic to assume that all market participants would adopt the same action in response. Some businesses may be late movers, others may be ahead of the curve. There may be multiple possible courses of action that a company could take in response to the same issue, and it would be reasonable to assume that different market participants may react differently depending on their specific circumstances. The potential response of competitors could affect how the entity performing the RST would respond.

Likelihood of circumstances arising

Once a company has identified the adverse circumstances which, in combination, could lead to the failure of the business, management will want to consider the likelihood of each of the relevant circumstances arising. This will help when evaluating the severity of any related weakness or vulnerability in the business plan and ascertaining what mitigating actions are appropriate in response.

It may be useful to conduct a sensitivity analysis when considering the likelihood of each circumstance – would the situation have to be very severe to jeopardise the business plan, and if so, how likely is it that such a severe circumstance would arise? Or, alternatively, is there a circumstance that is unlikely to occur, but would have a disproportionately large impact on the viability of the business if it did?

Thinking about the likelihood of the scenario arising against the relative impact on the business is critical in determining what action should be taken in response to protect the company. If the circumstance is unlikely to come to pass and would have to be very severe to impact the business, then it may be appropriate to take no action. If the opposite is the case, then the company should prioritise putting a more substantive response in place. 

Management actions

There are several different kinds of actions available to management in response to the findings of an RST. Some are in the entity’s control, such as deciding to invest more in a particular area of the business, whereas others may not be. For example, an oil company may be required by government to organise and fund a clean-up operation if a polluting event occurs. 

The actions under management’s control can be captured at different points within the RST. Certain measures might flex naturally, such as manufacturing more or less product, whereas other actions are more interventionist, all-or-nothing decisions which might come into play as circumstances become more challenging. This could include disposal of a business segment or raising new capital.

The actions available exist on a spectrum and it is worth considering how they may scale up, or down, as the company’s circumstances become more challenging.

Number of RSTs

Deciding to perform a certain number of RSTs per year runs the risk of creating a tick-box approach, performing RSTs by rote rather than seriously considering all of the different variables that could impact the business.

Companies should not lose sight of the purpose of the RST, which is to provide useful information about vulnerabilities in a firm’s business model and strategy. The specific circumstances and principal risks faced by a company, combined with the level of uncertainty the business faces in the wider economic environment might suggest to management that performing more than one RST might be necessary to gain a full understanding of the risks.

Situations in which more than one RST might be indicated, include where there are multiple possible definitions of business failure which cannot be contained within a single reverse stress test, or where multiple potential adverse circumstances have been identified which would be incompatible within the same scenario.