A bank stress test is a simulation or analysis conducted to analyze how a bank will be impacted under adverse market conditions – for example, a financial market crash or recession.
The analysis is conducted by stress-testing a bank’s balance sheet under hypothetical market conditions and economic variables, i.e., a 10% crash in equity markets or a 15% increase in unemployment. The main purpose of a bank stress test analysis is to determine whether a bank possesses enough balance sheet strength to withstand a financial crisis.
Regulatory authorities and central banks globally require all banks of a certain size to undergo stress tests. In the United States, banks with assets greater than $50 billion are obligated to undergo stress tests conducted by the Federal Reserve.
Breaking Down a Bank Stress Test
A bank stress test analyzes how a bank’s balance sheet will be impacted by an adverse change in the above economic variables. Stress tests run several scenarios with the variables above and others. Below are examples of common scenarios that might be run in a stress test:
How will an X% change in interest rates impact the bank’s financial position?
What happens if unemployment rises by X% in year Z?
What happens if the GDP falls by X% and unemployment rises by Y%?
What happens to the bank’s assets if the stock market crashes by X%?
How does the bank’s exposure change if oil/precious metal prices fall by X%?
What happens if the FX rate with country A depreciates by X%?
What happens if there is a housing market crash of X%?
Stress tests determine the financial health of banks in periods of financial turmoil by running model simulations like the ones above. Running such scenarios is a tedious job, as a lot of variables go into such models.
The central bank of a country generally provides a basic framework for running stress tests. The three key areas stress tests focus on the most are credit risk, market risk, and liquidity risk.
Why are Bank Stress Tests Important?
Bank stress tests were introduced globally after the Global Financial Crisis of 2008. It exposed the holes and weaknesses in banking systems worldwide. The crisis wiped out large banks in several countries and left financial institutions across the globe in financial distress.
Post-2008, regulators worldwide realized that large banks in any country were critical for the smooth functioning of that economy. The institutions were deemed as “too big to fail,” as they had the potential to cause widespread economic harm if they failed.
Bank stress tests were introduced in 2008-2009 in response to the financial crisis. International financial authorities required all banks of a certain size to undergo periodical stress testing and publish the results. Banks that failed stress tests were required to build up their capital reserves.
A key benefit of stress testing is the improvement in risk management. Bank stress tests essentially add another layer of regulation, which forces financial institutions to improve risk management frameworks and internal business policies. It obliges banks to think about adverse economic environments before making decisions.
Moreover, since all banks over a certain size are required to conduct periodical stress testing and publish the results, market participants have much better access to information regarding the financial position of major banks. This increases transparency in the banking system.
Types of Stress Tests
The type of stress testing a bank needs to undergo depends on the size of the bank and the regulations in the country in which it operates. The two commonly used stress tests for banks in the United States are the Comprehensive Capital Analysis and Review (CCAR) and the Dodd-Frank Act Stress Test (DFAST).
1. Comprehensive Capital Analysis and Review (CCAR)
Banks with more than $100 billion in assets are required to undergo CCAR testing. Financial institutions with more than $250 billion in assets are required to undergo more comprehensive CCAR testing, which may include additional qualitative and quantitative elements than the regular CCAR. Qualitative elements of the test focus more on internal risk management frameworks and policies.
2. Dodd-Frank Act Stress Test (DFAST)
The DFAST is for the largest financial institutions (with more than $250 billion in assets). All banks that fall in the category must satisfy DFAST requirements and send periodical test results to the Federal Reserve.
Central banks of other countries follow similar frameworks for stress testing.
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