By Joseph Neu
It’s not as if we want to give regulators the idea but eventually, they, along with auditors and the rating agencies, are likely to call for corporates to subject themselves to stress-testing and disclose the results. The impact of supervised stress testing on banks, from the perspective of regulator power and creating investor confidence, is simply too compelling for it not to spread.
How it might work
Corporate stress-testing might be “supervised“ by SEC regulators in some fashion, by auditors or, also, imposed as a replacement for traditional ratings. Essentially, the SEC would sanction scenarios, much like the Fed is doing with CCAR and now Dodd-Frank Authorized Stress Tests, that corporates would use to stress their earnings, cashflows and capital structures.
Even if no minimum targets are set, by forcing firms to disclose, say, leverage, interest coverage ratios, excess cash levels and other key metrics under standard normal and adverse scenarios (validated to approved models), market participants would have a new means to determine their financial health relative to peers.
Rating agencies might even still assign a letter-grade based on how well a firm passes such stress tests.
Shareholders, further, would have another set of benchmarks to assert that additional distributions are practical. And, conversely, firms would have a means to hold shareholder activists at bay; for example, using cash distribution impacts under stress.
Hopefully, this last bit won’t be the only silver lining if this transference of bank stress-testing becomes real.
Fortunately, though, without a corporate-led financial crisis to accelerate them, supervised stress tests for non-financial corporations will take some time to take hold.
Bring into Risk Management
This means corporates can be proactive and think about how to incorporate similar types of stress-testing into their current strategic and financial planning. The challenge now for banks is how to integrate the regulatory stress-testing (and capital plan submission process), rushed into place by the financial crisis, into their pre-existing internal processes for risk management, capital allocation, funding and excess capital distribution.
With the benefit of time, corporates have a better chance of helping to develop the testing models and scenarios that they might ultimately be subjected to. This way their internal processes will be more likely to match up, and not become a separate compliance mandate that duplicates them.
A good place to start, as we noted when the bank stress tests first appeared (see “Stressing Banks and You,” IT March 2009) is with corporate ERM programs. Since the discipline of enterprise risk management has largely grown out of the banking sector and efforts to increase the sophistication of bank capital management, the approach taken by US bank regulators is already heavily influencing ERM’s future.
Also, as we noted then, non-financial firms’ ERM programs are looking for practical frameworks that will help them avoid the failures of bank ERM functions to avert disaster. Standardized stress tests are worth a good look. The stress-testing paradigm would appear to fit, too, with the financial planning and analysis functions working on economic and business scenario analysis to help support better business decisions, which are high on CFOs’ lists to improve.