June 2007 Capital Adequacy Extension © Copyright 2007, CCRO. All rights reserved. Page 68 of 92 7. BUSINESS RISK, STRESS TESTING, AND THE RISK CAPITAL DETERMINATION 7.1. Introduction In the history of bankruptcies and massive trading losses, it was not necessarily the events that occur within the normal distribution of potential outcomes that caused the negative event it was the events that occurred outside the normal distribution. It is important to understand the range of risks that could potentially have an affect on earnings that have not already been captured within the Market, Credit, and Operative risk analysis. What is classified as Business Risks should play an integral role in Stress Testing. Business risks refer to the ‘uncertainty of future financial results related to business decisions that a company makes and to the business environment in which to company operates.’30 Risks that fall within this category can include: • Sales Risks • Marketing Risks • Competition Risks • Reputational Risk • New Product Acceptance Risks The aspect that separates Business risks from most market, credit, and operative risks is that shareholders pay management to take business risks and to manage market, credit, and operative risks. Some business risks may be micro economic in nature and some may be macro economic. It is important during stress testing to have a solid understanding of the potential business risks that have an effect on the Market, Credit, and Operative Risk factors and/or Earnings components. Stress Testing does not just focus on business risks alone. Individual market, credit, and operative risks should also be individually stressed. For example, a stress test of Market risks might include what power prices would be on a peak day should a key transmission line snap. In addition to stress testing Market Risks (power prices) this example also highlights how Operative risks (transmission line snap) can be incorporated into the Stress Testing of the earnings results. The process for Stress Testing can be broken into the following essential components: 30 CorporateMetrics, The Benchmark for Corporate Risk Metrics. Technical Document. Risk Metrics Group. 1999. Pg 5