June 2007 Capital Adequacy Extension © Copyright 2007, CCRO. All rights reserved. Page 69 of 92 • Identify all Material Risks not already captured in Market, Credit, and Operative risk measurements • Define how these risks impact earnings components directly or vis-à-vis the Market, Credit, or Operative Risk Factors • Determine the potential impact to equity as a result of these risks Ultimately the intent of stress testing is to understand how various events not reflected in the standard analysis will affect the earnings distribution determined during the measurement of market, credit, and operative risks and to determine the potential earnings that could occur ‘Outside the Normal Distribution’. Stress testing examples can include asking the following questions: • “What will happen if…..?” • From a Business Risk Perspective • “What if demand fell by 30%?” • “What if a new competitor entered the market, reducing market share by 25%?” • “What if a pipeline exploded, reducing import capacity by 25%?” • From a Market Risk Perspective: • “What if cost of Natural Gas Increases 50%?” • “What if value of Currency decreases by 75%?” • “What if Power Prices Drop by 30%?” The answers to these questions will ultimately affect the measurement that was established when the impact of market, credit, and operative risks were determined under normal circumstances. Based on that, one can determine the appropriate amount of the Risk Capital requirement. With Credit, Operative, and Market Risk, the Risk Capital requirement is predicated on potential losses that reduce the amount of equity to fund capital requirements. To realize the full extent of the potential losses, stress testing the measured risks becomes essential. To the extent that earnings fall short of expected values, while upsetting to shareholders, does not reduce the amount of equity available to fund capital requirements, unless those earnings fall below $0, whereupon the company must then look to potentially fund additional capital requirements. Recall from Figure 3.6, that any positive earnings results in enhancement to equity and increases the ability to fund capital requirements, and conversely negative earnings will reduce the equity.