Taking the stress out of stress testing

Whilst the accuracy of Wikipedia can sometimes be questioned, the above statement is quite accurate when considered alongside the Regulator’s requirements in the new Regulatory Framework in relation to stress testing.

Throughout the consultation on the new Regulatory Framework the Regulator has emphasised the need for effective governance and robust internal arrangements to protect social housing assets thereby ensuring value is not lost to the sector (and other key stakeholders). Against a backdrop of increasing diversification and the emergence of a variety of business models, the Regulator is focussing its attention on RPs being able to to identify and manage risks to their businesses (whether arising from the social housing business, the external operating environment or due to the activities of an organisation within its group).

Many will recall that the original discussion paper published in April 2013 identified ringfencing as a way for the Regulator to police the risks arising within an RP’s business. There was a collective sigh of relief when this proposal was dropped in favour of an approach which places the onus on each RP to identify and manage the risks themselves. One of the tools prescribed by the new Regulatory Framework which will help RPs to understand risk is “stress testing”. This concept of stress testing was emphasised in the Cosmopolitan Housing Group Lessons Learned Report published in June 2014 which recommended that scenario-testing was carried out by Boards to identify circumstances which would break the business.

The Regulator, through stress testing, is looking for RP Boards to be in a position to spot problems before they become significant issues that might break the business or require the involvement of the Regulator.

The revised Governance and Financial Viability Standard includes stress testing as a new expectation and states “all registered providers shall assess, manage and where appropriate, address risks to ensure the long term viability of the registered provider, including ensuring that social housing assets are protected. Registered providers shall do this by……carrying our detailed and robust stress testing against identified risks and combinations of risks across a range of scenarios and putting appropriate mitigation strategies in place as a result.”

So what are the expectations of the Regulator with regard to stress-testing and risk management?

Board engagement….

The Regulator has been clear that stress testing is something that the Boards need to be involved in. Stress testing is part of the risk management approach of an organisation that will be used by Boards and executive teams when developing future business strategy. Boards need to understand the business (organisation-wide) being carried out by the RP and, more importantly they need to understand the risks that could impact on the organisation. For example, if an organisation is considering acquiring a social enterprise that will sit as a separate organisation in a group structure, can the rest of the group really ‘walk away’ from this venture (despite it being ring fenced) if things start to go wrong. What reputational impact could this have? Do the Board understand the exposure of the organisation to major contracts? The expectation of the Regulator is that stress testing is something that should lead to debate at Board level on risks which could impact on the business(es) and how these can be controlled and/or mitigated.

Not a spreadsheet modelling exercise….

The Code of Practice is clear that stress testing is something that is more far reaching than simple sensitivity testing and includes multi-variate analysis to test against a range of financial, economic and operational risks. Boards will need to develop plausible scenarios that will really test an organisation’s plans against risks in the operating environment. In looking at scenarios, some have pointed to the Bank of England stress tests (see below for more on this) but Boards need to consider whether this really is an appropriate range of tests and this will depend on the size, type and structure of your organisation, how diverse your business is, whether you have an active development programme or not (amongst other things). The Code of Practice does include two possible examples which may assist organisations.

What will break an organisation and then….

It doesn’t just end with the carrying out of the stress testing…this exercise is not only about identifying the risks to the business but also about establishing ways for the business to survive such risks – i.e. risk management.

Information from any stress testing can (and should) be used on a number of levels by Boards – to aid the development of hedging strategies, to provide an understanding and adjustment of risk appetite by an organisation and it should lead to the establishment of cushions and mitigation strategies. Mitigation strategies might include looking at whether you have properties available for charging at short notice (that are going to be easily charged and are not properties that haven’t already been charged because they fell into the ‘too difficult’ box), what your covenant headroom is you have as an organisation, what level of exposure should you have to sales at any one time.

Ultimately, if an organisation understands the risks it could face but also has controls in place that allow it to limit its exposure or to extract itself from a tricky situation and this can be demonstrated to the Regulator then the Regulator is likely to be satisfied that you have done your homework in relation to stress testing.

The term ‘stress test’ in a financial sense is a test whereby the robustness of financial institutions to deal with an economic crisis is tested. There are a number of prescribed ‘stresses’ that are used by the governmental bodies that include:

• What happens if unemployment rises to [ ]% in a specific year?
• What happens if GDP rises by [ ]% in a given year?
• What happens if interest rates go up by at least [ ]%?
• What happens if the equity markets crash by more than [ ]% this year?

Whether these are appropriate ‘stresses’ for your business will depend on your size, structure and type.

Contact Natalie Singh on natalie.singh@anthonycollins.com or 0121 214 3718.

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