An early warning system for the worst-case scenario

In addition to the conventional stress tests that have been standard practice since the financial crisis, some financial institutions are already using reverse stress tests. Unlike regular stress tests, reverse stress tests assume an event – such as a decline in the solvency ratio – and then analyse backwards to determine what could lead to this outcome. The range of potential events can range from simple counterparty default to a decline in earnings power to the insolvency of the financial institution.

This enables financial institutions to identify particularly high-risk sectors, products, business areas and companies. In addition, reverse stress tests can be used to identify a large number of individual, potentially high-risk scenarios, whereas conventional stress tests only examine individual risks.

Companies should therefore also consider reverse stress tests. For treasury departments, whose core tasks include financial stability and liquidity management, they offer the opportunity to identify weaknesses, potential capital requirements and dependencies as part of risk management and to strengthen the strategic resilience of the company. Possible areas of analysis include problems in supply chains, cyber risks and geopolitical conflicts.

Based on the investigations and the assessment of the probability of the scenarios occurring, contingency plans and concrete measures can then be derived. These include, for example, adjusting dividend payments, adjusting business growth, using capital issues or credit risk-related measures such as improving asset quality, adjusting credit limits or restructuring customer relationships.

Such analyses become particularly important in times of political crises. Treasury departments can use them to raise management's awareness of the potential financial impact of crises at an early stage, establish themselves even more firmly as strategic sparring partners for company management and make an even more decisive contribution to the company's success.

Keeping an Eye on Risk Premiums

Last but not least, the use of reverse stress tests offers treasury departments the opportunity to improve or maintain credit terms, as it is conceivable that banks will take greater account of the impact of the relevant scenarios in reverse stress tests on their capital adequacy when pricing loans in future. Companies whose business model or approach to risk in such scenarios appear particularly risky could face higher risk premiums. Conversely, companies that use reverse stress tests to demonstrate that they remain resilient even under extreme conditions can present their risk position to banks more transparently and thus actively contribute to more favourable financing terms.

Banks Under Obligation

Companies that use reverse stress tests as a communication tool with banks and investors to make their own risk competence and crisis preparedness even more visible are in a position to proactively exert a positive influence here. This issue could become even more important in view of the reverse stress test focusing on geopolitical risks, which will be mandatory for all banks for the first time in 2026.

Author

Jan Jelovsek is CoE Lead Integrated Risk at ING Germany.