What is Stress Testing?
Stress testing is a computer simulation method used to assess financial institutions and investment portfolios’ ability to withstand future economic uncertainties.
It is often used alongside management systems and internal models to estimate risks and make them more transparent. In such a way, an institution or portfolio manager can gauge the adequacy of assets and investment risk to make capital allocation decisions and lay down hedging strategies.
Companies are currently required to conduct stress testing scenarios to ensure their asset and capital holdings are adequate to cushion them against extreme market events.
- Stress testing is a risk management technique used in financial institutions and investment portfolios to assess the capital level necessary to endure future financial situations.
- Stress testing practices are both quantitative and qualitative in nature and factor in the market risks and liquidity capital as components of market disturbances.
- Companies and investment managers use different stress testing approaches, depending on the potential threat in the market.
Understanding Stress Testing
For most companies that manage stock, the history of returns provides insufficient information regarding the likelihood of a market crisis. Therefore, stress tests are used to reveal the appropriate level of capital necessary to mitigate losses in the event of a deteriorating market condition.
Managers use stress testing programs to determine whether the firm or portfolio investment’s exposures correspond to their risk appetite. It facilitates dialogue among risk managers and other concerned parties about the company’s risks and internal controls measures to monitor and manage those risks. It complements value at risk (VaR) for tracking the riskiness of a company.
Quite often, asset and liability matching is one of the proprietary stress testing programs used by companies that seek to set risk limits and manage liquidity and capital. Stress testing is typically a single element through which qualitative and quantitative risk management policies are developed.
Regulatory Stress Testing
Internationally active financial institutions started applying stress testing practices in the early 1990s. However, following the 2007-2008 Global Financial Crisis, heightened regulatory reporting for the financial industry ensued, especially for financial institutions.
The focus of the expansion was on stress testing and the conservation of adequate capital. Banks were required to stress test their management strategies and report the outcomes that reflect their risk characteristics to senior managers and the banks’ board of directors.
At the onset of 2011, new regulations in the U.S. compelled the submission of stress testing documentation according to the Comprehensive Capital Analysis and Review (CCAR). The new regulation conditioned financial institutions to conduct plausible stress tests on their internal procedures and report their capital management strategy.
In the case of large banks that the Financial Stability Board considers unlikely to fail – usually, those with assets not less than $50 billion – the banks are required to report stress testing on a bankruptcy scenario. In 2018, a total of 22 banks were rated too big to fall.
Methodologies of Stress Testing
Stress testing is used to identify a company’s capacity to absorb losses. Several models are used to conduct the exercise. The methods vary from simple to complex approaches that seek to estimate the impact of severe microeconomic stress scenarios.
1. Historical scenarios
Historical scenarios assume that known and constant statistical processes drive market risks. The simulation is run based on a past crisis to assess asset class, business, individual investment, or portfolio investment. Examples include the Dot.com Crash of 1999-2000 and the Crash of October 1987.
The hypotheticals method specifies how a particular company can sustain a specific risk exposure. For example, a company may conduct a self-test against a speculated earthquake and devise how to wade through the event.
3. Stylized scenarios
The stylized scenario methodology is, to a large extent, scientific in nature. Typically, a single or a few test variables are adjusted concurrently. For example, the test might involve the S&P 500 Index losing 15% of its value in a month.
Most simulation software uses Monte Carlo simulation to run such tests. It can model the probabilities of different results using specific variables.
Companies can use risk management and software providers, depending on the type of stress test needed. A typical example of a professionally managed stress testing program used to assess potential risk in an investment portfolio is Moody’s Analytics.
Limitations of Stress Testing
The main limitation of stress testing is that it quantifies exposure to adverse market movements, but not the likelihood of such an event occurring.
Decisions that determine stress testing methodology to be used by a company heavily depend on the risk managers’ experience and judgment. It means that a manager might select an unsuitable scenario or interpret the stress testing results inappropriately.
Stress testing practices also come with high computational costs, especially with data collection from various business units, as well as from the need to place hedging strategies of option-based positions.
Another limitation is that most of the current stress testing practices cannot incorporate credit risks and market systematically.
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