In the ever-evolving landscape of financial planning, stress testing has become a vital compass for housing associations, navigating through uncertainties in the economic realm. While regulatory mandates play a role in its prominence, the growing economic unpredictability has spurred management teams and boards to seek stress testing as a proactive measure.
In this blog, we delve into the intricacies of stress testing, exploring both the deterministic and probabilistic approaches that guide housing associations in safeguarding their financial plans with the right mitigation measures.
Traditionally, stress testing has often adopted a deterministic approach, constructing scenarios by hand that anticipate the future in a linear manner. These scenarios, formulated as expectations, provide a snapshot of how economic and financial variables could evolve. However, it's essential to recognize the limitations of this method, as deterministic scenarios might oversimplify the complex interplay of risks and returns. Perfect storm scenarios, though attention-grabbing, may overstate risks and fail to encapsulate the full range of uncertainties.
Drawing inspiration from financial industries like pension funds and insurance companies, housing associations in the Netherlands are increasingly embracing a probabilistic approach. This involves employing tools such as an Economic Scenario Generator (ESG) or Monte-Carlo scenarios to model the behaviour of economies and financial markets. Unlike deterministic scenarios, a probabilistic model acknowledges that history is just one specific realization of events. By generating numerous scenarios, each representing a possible evolution of the future, a more nuanced understanding emerges.
Calibrating an ESG allows for running scenarios repeatedly, mimicking the diversity of historical outcomes that might have occurred. This approach introduces the concept of probability, categorizing scenarios as more or less likely. The greatest advantage lies in its ability to pinpoint the most critical risk drivers specific to each Housing association's plan.
Identifying risk drivers
The probabilistic approach acts as a reverse engineering tool, unveiling the risk drivers for each unique plan. For instance, a Housing association aiming for ambitious new developments may find its sensitivity tied to the building cost index. Similarly, initiatives like shared ownership programs could amplify sensitivity to the house price index. By tailoring stress scenarios to individual plans, organizations gain a comprehensive understanding of potential risks and their probabilities. And that will help them to find the right mitigation measures.
Navigate with precision
Stress testing has transcended its regulatory roots, becoming a proactive strategy for Housing associations to fortify their financial plans against economic uncertainties. While deterministic scenarios offer a glimpse into possible futures, the probabilistic approach adds depth by assigning probabilities to different outcomes. By identifying plan-specific risk drivers, organizations can navigate the complex landscape with precision, ensuring resilience and adaptability in the face of an ever-changing financial environment. Stress testing is not merely a regulatory requirement; it's a strategic imperative for Housing associations looking to thrive in the dynamic world of finance.
Housing associations create a multi-year budget, which showcases the expected development of the financial results. An essential component of the multi-year budget is identifying the financial risks in the balance sheet and cash flow trends. The probabilistic scenario approach helps to identify the risk drivers for each plan and that way helping to find the rights answers to mitigate the risk.
For questions, please contact David Kronbichler, find contact details below.