3.1 Both stress testing and scenario analysis are forward-looking analytical techniques, which seek to anticipate possible losses that might occur if an identified economic downturn or a risk event crystallises.

3.2 Stress testing typically refers to shifting the values of individual parameters that affect the financial position of a firm and determining the effect on the firm’s financial position.

3.3 Scenario analysis typically refers to a wider range of parameters being varied at the same time. Scenario analyses often examine the impact of adverse events on the firm’s financial position, for example, simultaneous movements in a number of risk drivers affecting all of a firm’s business operations, such as business volumes and investment values.

3.4 There are three broad purposes of stress testing and scenario analysis:

(i) as a means of quantifying how much capital might be absorbed if an adverse event(s) occurs;

(ii) to provide a check on the outputs and accuracy of risk models, particularly in identifying non-linear effects when aggregating risks; and

(iii) to explore the sensitivities in longer-term business plans and how capital needs might change over time.