Fail the Stress Test? You're FiredMichael Schrage
Posted on Harvard Business Review: July 8, 2010 8:41 AM
Fail a stress test on a doctor's treadmill? You get whisked to the hospital for emergency bypass surgery. Good luck. Troubled business unit fails a stress test? You get fired. Good luck.
Global economic crises and government oversight have pushed stress testing into the heart of business best practice. If you think you're stressed out now working at a publicly traded — or publicly regulated — enterprise, grip your guardrails tight: Your firm's stress-testing treadmills will soon be shifting into overdrive. Passing stress tests had better be your new core competence. You'll be taking more of them.
When Timothy Geithner's Treasury Department first proposed stress tests for America's embattled banks back in 2009, the initiative was widely derided as gimmick. In retrospect, financial sector stress testing is now regarded as a turning point. The greater transparency, insight and confidence that stress testing engendered played a significant role in boosting investor confidence. Yes, uncertainties and uncomfortable questions about stress testing results persisted. But few people now argue that stress testing was a futile or failed exercise in oversight.
Imitation remains the sincerest form of flattery. The PIIGS crisis has prompted Euro regulators to impose their own brand of stress testing on their continent's banks. These stress tests are every bit as controversial as their New World predecessors. But everyone, especially investors, takes them seriously. Will they be seen as helpful and successful as the American experience? Who knows? But crisis has effectively institutionalized stress testing as a core enterprise risk management practice. That's huge.
Even casual observers of the financial crisis have asked, "Isn't stress testing something these banks should be doing anyway?" Apparently not. Which is why we'll see non-executive directors in boardrooms of companies around the world import and impose stress testing as their way to demonstrate good governance to investors and regulators alike. The failed oversight of financial services is their fear and their spur. Boards are going to have to become more pro-actively involved in overseeing and dynamically assessing enterprise risk. Stress testing is now an accepted — and expected — method to show enterprise strength. Do it, or else.
So we'll see stress testing by energy companies on how well they might manage, say, a deep seawell blow out. Utilities will stress test their grids and networks to show that crises can be mitigated and recovery times accelerated. Airlines will stress test their business models for whatever follows Icelandic volcanoes as a system-wide shutdown threat.
Needless to say, this sounds suspiciously like contingency plans and business continuity initiatives that many organizations are already required to perform. You would be (almost) correct. As the financial stress tests humiliatingly demonstrated to managements and boards alike, the difference between 'plans' and 'tests' are enormous.
Stress testing's impact depends on its dynamic simulation of worst-case outcomes. The stress tests moved the conversation beyond arguments around contingency plans to operational challenges based on explicit numbers. As President Eisenhower once reportedly remarked, "Plans are worthless, but planning is valuable."
The financial crises revealed the majority on contingency/continuity plans to be worthless. The challenge of running and responding to stress test results apparently forced a superior quality of planning interaction among regulators, boards, and management. Does any serious investor believe that the virtue and value of stress testing should be confined to the financial services sector?
Between ambitious regulators, activist investors, and nervous directors, the business world is going to find compliance redefined away from diligently following detailed checklists and towards the innovative design of stress-testing treadmills. Who do you think will be trotting their numbers and scenarios on those treadmills, breathing harder and running faster?
Why, you will. Good luck.