Which of the following are valid objectives of a reverse stress test:

Which of the following are valid objectives of a reverse stress test:

I. Ensure that a firm can survive for long enough after risks have materialized for it to either regain market confidence, restructure or be sold, or be closed down in an orderly manner,

II. Discover the vulnerabilities of the current business plan,

III. Better integrate business and capital planning,

IV. Create a ‘zero-failure’ environment at the systemic level in the financial sector
A . I and IV
B . I, II and III
C . II and III
D . All of the above

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Answer: B

Explanation:

Statement I is true. According to the statement CP08/24: Stress and scenario testing (December 2008) issued by the FSA in the UK, an underlying objective of reverse stress tests is to ensure that a firm can survive long enough after risks have crystallized for one of the following to occur:

– the market decides that its lack of confidence is unfounded and recommences transacting with the firm;

– the firm down-sizes and re-structures its business;

– the firm is taken over, or its business is transferred in an orderly manner; or

– public authorities take the firm over, or wind down its business in an orderly manner. Statement II and III are true. The same statement clarifies the intention of the reverse stress testing requirement, which is to encourage firms to: explore more fully the vulnerabilities of their business model (including ‘tail risks’); make decisions that better integrate business and capital planning; and improve their contingency planning. Statement IV is incorrect. Since the question is asking for the statement which is NOT an objective for reverse stress tests, Choice ‘b’ is the correct answer. The same statement clarifies that the introduction of a reverse-stress test requirement should not be interpreted as indicating that the FSA is pursuing a ‘zero-failure’ policy. In the FSA’s view, such a policy is neither possible, nor desirable.