Reverse Stress Test: An Important Risk Management Tool

Abstract

In Reverse Stress Test (RST) the quest is for plausible exogenous trigger scenarios that might “break the bank.†RST is a nifty tool for thinking and experimentation with various test designs and configuration sets. RST has been advocated as a concurrent exercise to supplement the stress testing framework so as to avoid any possible myopic lapse in choosing scenarios as to the vulnerability of the bank’s business models. It helps address the concern that forward stress tests may miss the idiosyncratic vulnerabilities of individual firms. For most financial services firms, RSTs are not only a regulatory requirement but a risk management tool that grew in importance in 2020. The unexpected arrival of the COVID-19 pandemic shows how important reverse stress testing can be in managing business vulnerabilities.