As part of its business planning and risk management obligations under SYSC, a firm must reverse stress test its business plan; that is, it must carry out stress tests and scenario analyses that test its business plan to failure. To that end, the firm must:
identify a range of adverse circumstances which would cause its business plan to become unviable and assess the likelihood that such events could crystallise; and
where those tests reveal a risk of business failure that is unacceptably high when considered against the firm's risk appetite or tolerance, adopt effective arrangements, processes, systems or other measures to prevent or mitigate that risk.
The design and results of a firm's reverse stress test must be documented and reviewed and approved at least annually by the firm's senior management or governing body. A firm must update its reverse stress test more frequently if it is appropriate to do so in the light of substantial changes in the market or in macroeconomic conditions.
Business plan failure in the context of reverse stress testing should be understood as the point at which the market loses confidence in a firm and this results in the firm no longer being able to carry out its business activities. Examples of this would be the point at which all or a substantial portion of the firm's counterparties are unwilling to continue transacting with it or seek to terminate their contracts, or the point at which the firm's existing shareholders are unwilling to provide new capital. Such a point may be reached well before the firm's financial resources are exhausted.
The appropriate regulator may request a firm to quantify the level of financial resources which, in the firm's view, would place it in a situation of business failure should the identified adverse circumstances crystallise.
In carrying out the stress tests and scenario analyses required by SYSC 20.2.1 R, a firm should at least take into account each of the sources of risk identified in accordance with GENPRU 1.2.30R (2).
Reverse stress testing should be appropriate to the nature, size and complexity of the firm's business and of the risks it bears. Where reverse stress testing reveals that a firm's risk of business failure is unacceptably high, the firm should devise realistic measures to prevent or mitigate the risk of business failure, taking into account the time that the firm would have to react to these events and implement those measures. As part of these measures, a firm should consider if changes to its business plan are appropriate. These measures, including any changes to the firm's business plan, should be documented as part of the results referred to in SYSC 20.2.3 R.
In the light of the results of a firm's reverse stress tests, the appropriate regulator may require the firm to implement specific measures to prevent or mitigate the risk of business failure where that risk is not sufficiently mitigated by the measures adopted by the firm in accordance with SYSC 20.2.1 R, and the firm's potential failure poses an unacceptable risk to the appropriate regulator's statutory objectives.
The appropriate regulator recognises that not every business failure is driven by lack of financial resources and will take this into account when reviewing a firm's reverse stress test design and results.