Reverse Stress Testing

Abstract

This article outlines a framework for the analysis of extreme events based on forward-looking reverse stress testing. We perform a portfolio simulation and identify stress scenarios critical to the bank’s solvency. Stress scenarios are determined based on their contribution to the capital cost, as expressed by KVA scenario differentials. We find that reverse stress testing can identify both the systemic and idiosyncratic weaknesses of the bank’s portfolio without relying on historical events. Applications include solvency risk, extreme events hedging, liquidity risk management, trading and credit limits, model validation and model risk manage- ment.

Keywords: Model Validation, Stress Testing, Reverse Stress Testing, Capital Models, Risk Margins, Trading Limits, Cost of Capital, KVA, Model Risk, Short Rate Models, PFE

JEL Classification: D81, G13, G28, G32