In the wake of recent market shocks, global regulators are increasing their scrutiny of asset managers’ stress testing practices, particularly concerning liquidity and market risk. Firms must now shift their focus from treating stress testing as a compliance exercise to embedding it as a core component of strategic risk management. Asset managers must now consider how to strengthen their risk planning through more strategic and data-driven testing.
Regulatory Focus on Stress Testing
In recent years, the post-COVID recovery and the Liquidity-Driven Investment (LDI) crisis have propelled liquidity risk management to the top of the regulatory agenda. All major authorities, such as the European Securities and Markets Authority (ESMA), the UK’s Financial Conduct Authority (FCA) and the US Securities and Exchange Commission (SEC) now explicitly require asset managers to conduct regular and robust scenario analysis and stress testing.
Building a Robust Stress Testing Framework
As a result of this enhanced regulatory focus, firms must now adopt a best-practice framework for stress testing that is dynamic and deeply integrated into daily operations. To achieve this, firms should focus on the following key areas:
- Integrate testing into investment decisions: The outcomes of stress testing should be a key input for portfolio construction and investment decision-making, ensuring that potential risks are considered before committing capital
- Utilise diverse scenario planning: Frameworks must incorporate a range of severe but plausible scenarios, including historical events such as the 2008 financial crisis and hypothetical future events such as a rapid spike in inflation, as well as idiosyncratic scenarios tailored to the fund’s strategy or asset concentration
- Ensure engagement from senior management: Senior management should regularly review the outcomes of stress testing and consult with the board on the wider implications, building a clear governance process and ensuring that concrete actions are implemented to mitigate any weaknesses identified
What are the Key Weaknesses of Stress Testing?
Despite the pressure of evolving regulatory frameworks and increased scrutiny, many asset managers still demonstrate common weaknesses in their stress testing frameworks. An over-reliance on static models using historical data fails to reflect the speed of real-time market changes and can lead to a false sense of security. In a true financial crisis, historical correlations can break down, rendering these kinds of models ineffective. Many models also neglect to realistically represent the relationship between market stress and investor behaviour, often ignoring the potential for severe intra-day liquidity pressures or the cascading effect of large-scale fund redemptions on a particular asset class. Another significant weakness is the failure to connect stress test outcomes with governance requirements. If the outcomes from stress testing are not used to drive tangible actions, then the whole process becomes ineffective. Results from stress-testing should be used to inform risk appetite, adjust investment strategies or impact changes in governance procedures and client disclosures where necessary. If these outcomes are not achieved, the framework fails its strategic purpose and is likely to be considered a superficial compliance activity by regulators. During times of increasing market volatility and evolving regulatory expectations, stress testing can provide the foresight for firms to build strategic resilience in the wake of external threats and crises. For asset managers, stress testing helps to build a dynamic and integrated framework as the most effective solution for managing risk in volatile conditions to secure long-term stability. If your business requires assistance developing or reviewing existing stress testing frameworks, get in touch with Novatus Global today and one of our experts will explain how we can support your business.
