The UK’s Financial Services Authority will requiring firms to beef up their stress testing capabilities.

The regulator announced Friday that financial firms will be required to enhance their capital planning stress testing and it is introducing a reverse stress testing requirement for firms.

Reverse stress testing requires that firms identify and assess scenarios most likely to cause their current business models to become unviable. Firms subject to the new reverse stress testing requirement will have 12 months to incorporate reverse stress testing into their current suite of stress tests and risk management tools.

“Stress and scenario testing should be an important element in firms’ planning and risk management processes. These changes send a clear signal to firms’ senior management that they need to engage in building a robust stress testing infrastructure as an important part of effective risk management, and use that to assess capital needs in a stress,” said Paul Sharma, director of prudential policy for the FSA.

“Reverse stress testing is a separate, but complementary exercise. It is essential that firms identify what could cause their business to fail and use this information to ensure that the relevant risks are sufficiently well-understood and appropriately managed to secure consumer protection and market confidence,” he added.

The FSA added that it will also be recommending scenarios to help firms improve capital planning in 2010, and it published a consultation paper clarifying its approach to capital planning buffers (which is the amount of capital that a firm should hold now so that it is available to absorb losses and meet higher capital requirements in adverse external circumstances such as an economic downturn).

“This is an initial step in improving firm’s capital ahead of international discussions which will take place in 2010,” it said.

IE