June 2007 Capital Adequacy Extension © Copyright 2007, CCRO. All rights reserved. Page 75 of 92 8.3. Stress Testing, Trigger Events, and Other Contingencies Because of the unique circumstances of liquidity adequacy, it is important to highlight some aspects that should be incorporated into the stress test, above simply stressing Market and Business Risks as outlined in Chapter V. The Trigger Events and Other Contingencies should be incorporated into the stress test, again, to determine potential outcomes that reside “Outside the Distribution.” Trigger events are defined as material adverse changes and debt-equity changes and are usually contractual, whereas contingent events are events that create contingent liquidity requirements on liquidity. Examples of these types of events include: Trigger events: • Downgrade event – Loss of threshold – Adequate assurance • Debt/equity trigger Contingency events: • Operational/operations risk • Credit/counterparty termination default 8.4. Loss or Reduction of Threshold A loss or reduction of threshold would be triggered by a downgrade event to determine the contingent liquidity required because of a lower rating. Assume that contractually specified credit thresholds will go to zero in the event of a non-investment-grade trigger event or that the threshold will be reduced to a lower amount because of a lower investment grade credit rating. Loss or reduction of threshold represents the collateral that would be required to replace the amount of thresholds that are utilized. 8.5. Adequate Assurance Posting of adequate assurance can be required because of a loss of confidence in financial stability or trigger events. A two-notch downgrade to below investment grade could cause a substantial increase in contingent liquidity. (Or if an organization is close to non-investment grade, a downgrade to junk or single or double agency downgrades also make a difference.) Adequate assurance usually constitutes the majority of the contingent liquidity calculation when the downgrade event puts a company below investment grade. The calculation of adequate assurance can be the most difficult because of the subjective assumptions around management intervention. Adequate assurance is