2022: a wake-up call for stress testing
As we emerged from the impact of the Covid-19 pandemic 2021, treasurers and finance teams would have been forgiven for hoping for a period of relative stability. This ‘once in a lifetime’ event led to a total recalibration of how all businesses are run and gave reason to think through how business plans were put together once again.
However the impacts of these events were somewhat mitigated with it happening at the end of a sustained period of consistent low interest and low inflation. Despite this amenable economic environment, housing associations plans have been creaking under the weight of pressures brought by decarbonisation, stock improvement and fire safety spending.
Fast forward to today and the economic picture has deteriorated significantly. Putin’s invasion of Ukraine has destabilized the global economy and supply chains, driving up the cost of materials and leading to soaring inflation. These issues, which impact the day to day operations of all HAs, have been exacerbated by domestic political turmoil.
These factors combine to create the most challenging economic situation since the global financial crash in 2008 and HAs are having to think differently. A robust stress testing regime is now more important and more complex than ever. So what do social landlords need to consider going forward?
More frequent stress testing
Stress testing will appear on any finance team’s annual to do list, not least in regulated sectors such as social housing. Indeed, the Regulator of Social Housing (RSH) requires HAs to produce regular, detailed stress tests which can be checked during the In-Depth Analysis (IDA) process.
In reality, though, as a result of recent economic turbulence, HAs are beginning to stress test more and more regularly.
Jessica Friend, group corporate finance director at Platform Housing Group, explains that ever since the pandemic the group was already starting to stress test quarterly. She adds: “With the additional volatility and uncertainty in macroeconomic conditions, we have been running stress tests basically monthly.”
Vimal Gaglani, director of treasury and financial planning at Abri, says his organisation has also been stepping up stress testing due to recent economic conditions.
He says: “Ordinarily stress tests are done every year but they have become more important now because of what is going on in the economy and the underlying environment we are going into.”
It may well be that more frequent testing becomes the new normal and that the economic fluctuations of the last two years have demanded that financial planners reset their expectations of what is possible.
As Will Perry, Director of Strategy at the RSH, says: “People have been looking at their stress tests thinking: ‘what I was creating was as a perfect storm scenario is suddenly quite close to reality’ and that has really focused minds”.
Taking a varied approach
As well as more frequent testing, HAs will now be considering a wider range of variables that they need to build into stress tests. While planning for one off shocks is part of the process, few could have predicted the impact that the invasion of Ukraine would have on the global economy. On top of these one-offs, the RSH requires HAs to conduct multivariate analysis.
As Andy Lynch, Credit and Risk Manager at THFC, says: “A data breach incident, emergency decanting for a variety of reasons or regulatory action or regulatory action all require immediate significant cash outlay”.
Taking a mixed, multivariate approach to stress testing is necessary to reassure the regulator and others. As Andy explains: “We like to see scenarios that model the impact on debt levels, not just on covenants, as an organisation might run out of liquidity a long time before any covenant is breached”.
On top of this, Andy suggests that risks will not be the same across the board. For instance, sales risk may be key for one organisation, but another with lower operating margins may be exposed to greater risk by higher cost inflation.
As Vimal Gaglani notes, robust stress testing should also go further than just factors that lie within your core business. He says: “We have a number of joint ventures and we have some specific scenarios that we draw up for those joint ventures that we run.”
Mitigation and priorities
Identifying pressures, though, is just part of the picture. Arguably the most crucial step is to match these pressures with the mitigations you intend to use in each scenario.
As Jessica Friend explains: “I think stress testing itself is important but what I think will be even more important is identifying those mitigating measures and getting clarity from boards and executives on which measures you are going to take and in which order.”
Over the past two years HAs have been made to take some significant mitigation measures to ensure they protect the long term financial health of the organisation. There have been some high profile examples of HAs scaling back on development plans in order to focus spending on improving existing homes and undertaking decarbonisation works.
Given the latest set of financial pressures, Jessica says some organisations “may well be in a position where they simply cannot do decarbonisation work”.
She also notes that Platform itself had to moderate its development programme earlier this year, reducing projections from 2,000 units to 1,600, with this figure constantly being reviewed. This followed an announcement by fellow major developer, L&Q, that it would cut its housebuilding target by 70% due to fire safety costs.
Will Perry suggests that most providers will now be looking at how they can conserve cash, meaning they will be focused on current expenditure.
He says: “They will be figuring out what they can do to maintain covenant compliance while providing a reasonable level of service to tenants because you cannot compromise on safety and you cannot compromise on the basic services to tenants”.
On top of this, Will suggests the turmoil of the last year will have a knock on effect going forward. He says: “There are other long term decisions which I think will end up being postponed while providers try to figure out what the next five years look like.”
The social housing sector is facing a widespread crisis in housing disrepair and HAs are rightly looking inwards and considering how they can improve existing stock and reduce instances of damp and mould. This ongoing issue is likely to intensify spending in this area, and therefore reduce capital available to produce new homes.
Not a paper exercise
Mitigating measures will become a feature of HAs operations going forward. HAs will be trying to create extra financial headroom by reducing spending in areas like development and decarbonisation work. We are arguably already seeing the start of this process with more and more HAs being downgraded by the regulator.
For instance, in November the regulator announced it was downgrading 19 HAs and much of the sector will be braced for a second wave of downgrades. With this in mind, Will Perry urges HAs to treat stress tests as a whole organisation process.
He says: “There is a really important point about stress testing not being a paper exercise.
“It should be a practical thing that is a useful tool for boards and management teams in understanding their business. And boards should be challenging what they are presented with and what really lies behind it because it can be a way into understanding the business and where pressure might arise.”
Vimal Gaglani also highlights the importance of getting as many people involved in stress testing as possible.
“I think stress testing shouldn’t be exclusively a finance and treasury-led activity. It should be reflective of the conversations that you are having internally with all your different colleagues and around the business,” he explains.
Not two years are the same
The ever-changing economic picture means that, as always, predicting the financial pressure to come is a huge challenge. And a key difference is that HAs undertaking stress tests will now be doing so from a less favourable starting position.
“The next round of stress testing is going to be in a very different environment from what has been done today because the baseline position is going to be weaker,” Will Perry explains.
Will suggests stress tests will become more dynamic than previous ones as long term incremental mitigations will not be as effective in the ever changing economic situation.
Already HAs are have been handed a boost with the government’s announcement of a 7% rent cap. The move will help HAs with income levels meaning there will be less pressure to cut back on vital development and decarbonisation work.
However, the cap is currently set until the end of 2023, and no announcement has been made beyond that date. As such, HAs will still need to factor in potential for this rent cap to drop in future.
The future of HA finances is perhaps as hard to judge as it has ever been, which has reinforced to the sector the importance of stress testing. But going forward, according to Andy Lynch, there may need to be some changes in the way things are done.
He says: “Perhaps an aid to good stress testing – now and in the future – is to seek the views of a wide range of stakeholders, and potentially external consultants, to help avoid ‘group-think’ or a simple repetition and updating of what has gone before.”