Taking the Stress Test: Not Only for Banks, by Mark Chussil
The US government’s stress tests of banks found some wanting. That’s excellent! Early detection and preventive treatment are far better than early death and expensive clean-ups. Of course the stress tests aren’t perfect, just as medical screening isn’t perfect. Still, don’t we all wish those tests had been administered, oh, a year and a half ago?
The financial services industry may have precipitated the financial crisis but they are not the only ones who were unprepared for the shock. It’s not only AIG and Lehman Brothers. Chrysler, Circuit City, Filene’s Basement, and General Growth failed their real-life stress tests too. So have numerous companies even without the financial crisis.
Given the nature of the financial crisis it’s prudent to subject major banks to stress tests. It’s an equally terrific idea for companies in other industries to do the same. Not government-designed or -mandated tests. Rather, rigorous internal strategy tests designed to reveal the opportunities and threats that otherwise become apparent only in retrospect, and sometimes not even then.
I know most companies believe they do such reviews. Strategies pass budget reviews to the penny, market reviews to the last decimal place, and forecast reviews as far as the planning horizon can see. But, for the most part, that process is designed to advocate a strategy. It rarely stress-tests a strategy or contrasts the strategy with materially different alternatives. That’s why the stress tests my colleagues and I have conducted — we call them business war games and strategy simulations —lead to big, profitable surprises.
Stress tests for banks focus on capital requirements under a variety of economic scenarios. That’s necessary for banks, though it’s unclear whether it’s sufficient.
Companies in other industries need to be adequately capitalized too. But their capital needs don’t depend only on defaults, unemployment, and growth in the economy, and maybe not even primarily on those conditions. Perhaps (and perhaps not) unlike banks, companies in other industries are vulnerable to each other; that is, to the competition.
That’s obvious and noncontroversial. No strategist says competitors are irrelevant. What’s less obvious is that the traditional tools for stress-testing a business’ strategy do not adequately take competitors into account. Companies’ spreadsheets don’t have lines for “price cut required to match competitor’s panicky move.” Companies’ audits don’t include the quality of their products and services, relative to competitors’. Companies may assert that they will regain their historical market shares as they introduce new products but they don’t note the implicit assumption that those new products are being gauged against competitors’ old products. Companies may have to disclose that moves by major competitors are projected to have a material impact but not that tiny upstarts are moving into the market with odd new technology.
Those shortcomings happen even though we strategists know better, want to do better, and try hard to do better. They happen because the shortcomings are hardwired into the usual strategy-development tools. Remember that strategy development went on, in good faith, at those companies that failed.
Effective business war games and strategy simulations — that is, stress tests — ask the relevant questions. They ask how we’re going to respond to a panicky competitor. They judge whether our products and service are at a competitive disadvantage. They explore what new initiatives the competition might launch. They imagine how a tiny upstart might change everything. In a spreadsheet, there’s no entry for “my insight about the market.” There is, in a business war game.
There are three major benefits unique to stress-testing with business war games and strategy simulations.
First, they let strategists rehearse before they go on stage. The rehearsal surfaces assumptions and prevents oops-I-forgot-about-that problems.
Second, they let strategists experiment. Try Plan X35a. A flop? No problem. Press the literal or figurative reset button and try Plan B88q. Ditto with competitive, economic, social, and political scenarios.
Third, they let strategists challenge. Not in the sense of “how could you possibly believe that, you stupid pejorative.” Rather, in the sense of “If I were the competition, this is what I would do to derail our company.” Those challenges are intense, illuminating, and tremendously useful.
The point of stress tests isn’t to anticipate every scenario, let alone to prepare for them. That’s neither possible nor a good use of resources. The point of stress tests also isn’t to place blame for mistakes.
Rather, the point of stress tests is to prevent mistakes, including missing opportunities. Superior preparation is a competitive advantage, and it is possible to anticipate and prepare better than we have.
In my experience conducting business war games, the first outcome is to discover unforeseen problems, and the second — usually just a couple of hours later — is to find unrealized potential. The result is action toward improved performance.
You can conduct your own stress tests. For some advice based on ACS’ experience, see The Seven Deadly Sins of Business War Games and Learning Faster Than The Competition. For case studies, a.k.a. war stories, see You’ve Got The Data. Now What? For examples of testing scenarios, see When I Was Wrong and Millions of Pricing Simulations.
The risk many businesses run is not that they’re performing without a net. We all do that, every day. The risk is that they’re performing without rehearsing.
Stress tests aren’t just for banks. Come to think of it, they’re not even so stressful.