Stress test (financial)

• What happens if unemployment rate rises to v% in a specific year?
• What happens if equity markets crash by more than w% this year?
• What happens if GDP falls by x% in a given year?
• What happens if interest rates go up by at least y%?
• What if half the instruments in the portfolio terminate their contracts in the fifth year?
• What happens if oil prices rise by z%?
• What happens if there is a polar vortex event in a particular region?

This type of analysis has become increasingly widespread, and has been taken up by various governmental bodies (such as the PRA in the UK or inter-governmental bodies such as the European Banking Authority (EBA) and the International Monetary Fund) as a regulatory requirement on certain financial institutions to ensure adequate capital allocation levels to cover potential losses incurred during extreme, but plausible, events. The EBA's regulatory stress tests have been referred to as "a walk in the park" by Saxo Bank's Chief Economist. This emphasis on adequate, risk adjusted determination of capital has been further enhanced by modifications to banking regulations such as Basel II. Stress testing models typically allow not only the testing of individual stressors, but also combinations of different events. There is also usually the ability to test the current exposure to a known historical scenario (such as the Russian debt default in 1998 or 9/11 attacks) to ensure the liquidity of the institution. In 2014, 25 banks failed in a stress test conducted by EBA.

Bank stress test

A bank stress test is a simulation based on an examination of the balance sheet of that institution. Large international banks began using internal stress tests in the early 1990s. In 1996, Basel I was amended to require banks and investment firms to conduct stress tests to determine their ability to respond to market events. However, up until 2007, stress tests were typically performed only by the banks themselves, for internal self-assessment.

Beginning in 2007, governmental regulatory bodies became interested in conducting their own stress tests to insure the effective operation of financial institutions. Since then, stress tests have been routinely performed by financial regulators in different countries or regions, to ensure that the banks under their authority are engaging in practices likely to avoid negative outcomes. In India, legislation was enacted in 2007 requiring banks to undergo regular stress tests. In October 2012, U.S. regulators unveiled new rules expanding this practice by requiring the largest American banks to undergo stress tests twice per year, once internally and once conducted by the regulators. Starting in 2014 midsized firms (i.e., those with $10–50 billion in assets) are also being required to conduct Dodd-Frank Act Stress Testing. In 2012, federal regulators also began recommending portfolio stress testing as a sound risk management practice for community banks or institutions that were too small to fall under Dodd-Frank's requirements. The Office of the Comptroller of the Currency (OCC) in an October 18, 2012, Bulletin recommends stress testing as a means to identify and quantify loan portfolio risk. The FDIC made similar recommendations for community banks.

Since the Federal Reserve began conducting Dodd–Frank Act Stress Tests, post-stress capital levels across large banking institutions have generally increased. The Federal Reserve has also continued to expand its expectations over time by introducing more sophisticated and challenging stress-testing scenarios.

The Federal Reserve conducts its supervisory stress test annually using at least two scenarios and publishes bank-level results. The test estimates losses, revenues, expenses, and resulting capital levels under hypothetical economic conditions to assess whether large banks can absorb losses while continuing to lend. The Board uses the results in part to set each covered firm's stress capital buffer requirement.

Statistician and risk analyst Nassim Taleb has advocated a different approach to stress testing saying that stress tests based on arbitrary numbers can be gamed. A more effective test is to assess the fragility of a bank by applying one stress test and scaling it up, which provides an indicator of how sensitive a bank is to changes in economic conditions.