In 2017 the Bank of England (BoE) will introduce the biennial exploratory scenario (BES) as part of its annual concurrent stress test of UK banks.  Outlined as part of the BoE's 2015 update to its stress testing approach, the BES complements the annual cyclical scenario (ACS), enabling the BoE to assess firms' resilience to a wider range of threats.  The BES will be designed to delve into the more complex aspects of a firm's risk profile, in the process testing not just its resilience, but also its capacity to model and manage risk.

In this note we consider what the BES might look like, and what particular issues it could create for firms.

Thinking the unthought-of

The BoE is unlikely to release details of the BES before the 2017 test kicks off in the spring, but in our view the scenario is likely to be designed with several principles in mind:

  • Sufficiently dissimilar from the ACS (which we assume will capture macroeconomic elements associated with Brexit) to test firms' resilience to a wider range of emerging or latent threats, including those not directly linked to the financial cycle;
  • A tail-risk event that stresses all participants, but not necessarily equally; and
  • Alert to potential political sensitivities around possible outcomes.

Using these principles, we ran a PESTLE assessment – an approach widely-adopted by industry for analysing the business operating environment (Figure 1) – to assess which risk factors the BoE might look to stress.

Figure 1: the components of a PESTLE assessment

PESTLE theme

Definition

Example scenario attributes

Political

 

Extent to which a government(s) might influence the economy or a certain industry

· Several important European elections in 2017, with the potential to impact global trade and economies.

·       Ongoing instability in the Middle East and the increasing prevalence of referendums to settle major decisions compounding the risk of unlikely or unexpected outcomes crystallising.

Economic

 

Factors that determine an economy's performance that directly impact geographies, industries or individual companies

·        A market shock in interest rates, commodities or FX rates, outside the scope of the cyclical scenario.

·       T he failure of a major financial institution or central counterparty, and associated second order effects across the market.

Social

 

Factors that consider the social environment of the market, and determinants like cultural, demographics and population trends

·        A rapid, pronounced demographic change in the UK or Europe.

·        Longer-term implications of continued increases in life expectancy including on corporate pension fund deficits.

Technology

 

Innovations and disruptions in technology that may affect the operations of an industry

·        Failure of firms' critical IT infrastructure, possibly caused by a cyber-attack.

·        Disruptive effect on traditional banking services of the FinTech industry.

Legal

 

Internal policies or external laws that affect the business environment

·        Legacy conduct-related issues that may not be fully reflected on firms' balance sheets.

Environment

 

Factors that influence or are determined by the surrounding environment

·       Physical risks caused by extreme weather patterns or geologic events. 

·       Transition risks such as political or technologically driven efforts to reduce the impact of environmentally damaging actions.

In selecting a scenario the BoE will focus on its remit to protect and enhance the stability of the UK financial system.  It will also be mindful that some scenarios lend themselves better than others to stress testing, because of the practicality of modelling any risks or the timeline over which the risks might crystallise.  Some scenarios might alternatively be best assessed through other means.  For example, the potential for significant business model disruptions could be explored through supervisory business model analysis.

Drawing on our analysis, we illustrate below three scenarios that the BoE might explore.  Each example would take firms out of their risk modelling comfort zone and require an adjustment from traditional stress testing practices.

  • Negative interest rates: This would be an opportunity for the BoE to understand not only the financial impact but how firms' systems and infrastructure cope as they may not be set up to employ negative rates. Management actions would need to be developed carefully in order to fully understand the impact on customers.  Although the current guidance from the Monetary Policy Committee is that Bank rate is not expected to turn negative, this scenario foresees an exceptional circumstance.
  • Failure of a firm's largest Central Counterparty (CCP): Such a failure could cause severe disruption in financial markets, exposing firms to immediate settlement risk, and systemic risk in the short to medium term.  Systemic risk is difficult to model.  CCPs have complex funding arrangements and losses may be difficult to estimate.
  • UK natural disaster: An environment-related disaster resulting in a significant reduction in UK collateral values and losses associated with exposures to, for example, insurance firms.  Collateral information may be difficult to source at large scale.  Environmental risk is a niche field requiring specific expertise, and firms are in general inexperienced in modelling these risks. (The BoE recently sponsored a report highlighting the issue: 'Environmental Risk Analysis by Financial Institutions' that assesses the threat of environmental risks on the financial industry.)

How firms should prepare

The seven firms confirmed by the BoE as participating in the BES in 2017 will have to ensure they are prepared.  Key steps to consider now include:

  • Ensuring appropriate resource is in place to run two scenarios simultaneously.  The BoE is unlikely to change the timeline for firms and will expect standards of review, challenge and governance to be maintained.  Our 2015 Deloitte Stress Testing Survey highlighted a shortage of stress testing resource at banks across Europe.
  • Considering how scenarios which do not fit the 'usual' stress testing models will be quantified.  Should preparations be made to set up expert panels to undertake more qualitative expert-led assessments?
  • Linked to the preceding point, understanding key data gaps and limitations that could be exposed through new scenarios and assessing the firm's ability to address these in advance.

Even if the scenarios discussed here do not come to fruition in 2017, firms should consider this type of scenario assessment to inform their internal stress testing exercises (e.g. ICAAP) including those within Reverse Stress Testing and Recovery Planning.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.