Stress: Bank stress test
Bank Stress Test:
All about the stress test. What's a Bank stress test?

Discover all about the « Bank stress test ». Banks may suffer a risk of solvency or liquidity. Discover the « Bank stress test » for financial firms.

What is a « Bank stress test » ?

What is a stress test?

« Stress testing » has been adopted as a generic term describing various techniques used by financial firms to gauge their potential vulnerability to exceptional but plausible events. The most common of these techniques involve the determination of the impact on the portfolio of a firm or business unit of a move in a particular market risk factor (a simple sensitivity test) or of a simultaneous move in a number of risk factors, reflecting an event which the firm’s risk managers believe may occur in the foreseeable future (scenario analysis).

The current use of stress tests by financial firms

The scenarios are developed either by drawing on a significant market event experienced in the past (historical scenarios) or by thinking through the consequences of a plausible market event which has not yet happened (hypothetical scenarios). Other techniques used by some firms to capture their exposure to extreme market events include a maximum loss approach, in which risk managers estimate the combination of market moves that would be most damaging to a port folio, and extreme value theory, which is the statistical theory concerned with the behavior of the “tails” of a distribution of market returns.

Stress testing and value-at-risk

In most of the interviewed firms, stress tests supplement value-at-risk (VaR). VaR is thought to be a critical tool for tracking the riskiness of a firm’s portfolio on a day-to-day level, and for assessing the risk-adjusted performance of individual business units. However, VaR has been found to be of limited use in measuring firms’ exposures to extreme market events. This is because, by definition, such events occur too rarely to be captured by empirically driven statistical models. Furthermore, observed correlation patterns between various financial prices (and thus the correlations that would be estimated using data from ordinary times) tend to change when the price movements themselves are large. Stress tests offer a way of measuring and monitoring the portfolio consequences of extreme price movements of this type.

How do firms use stress tests?

Stress tests enable managers to track a firm’s exposure to price changes during events that are considered plausible, without obliging them to develop a statistical model for such events. This, in turn, allows senior management and business-unit heads to determine whether the firm’s exposures correspond to its risk appetite. Because of their intuitive appeal, stress tests are thought to facilitate the dialogue between risk managers, senior managers and business-unit heads about the risks taken by the firms and methods for monitoring and managing those risks. From this process decisions emerge regarding such matters as the limits set on proprietary position-taking, capital charges on traders and trading units, and the appropriateness of the risk-managers’ modeling assumptions. It should be emphasized that stress tests are typically only one element of the process through which a financial firm develops its quantitative and qualitative risk-management policies.

Consolidated stress testing at the firm level

Consolidated stress testing at the firm level was introduced in response to the amendment to the Basel Capital Agree in 1996, which made approval of the “models approach” to a firm’s market risk capital requirement conditional on the presence of a firm-wide stress test program. However, individual trading desk managers at many firms had, at their own initiative, put in place stress test programs well before the creation of corporate-level programs. Particular interest has been devoted to stress testing since the financial crises in Asia in 1997 and the turbulent events of the autumn of 1998. The group found that most of the interviewed firms are increasing the resources devoted to developing stress tests.

Scenario analysis methodologies

The interviewed firms tended to use both historical and hypothetical scenarios. Historical scenarios are easier to formulate and to understand intuitively. Hypothetical scenarios allow risk managers to challenge the common tendency to pay more attention to past events than future dangers. In both cases, scenarios are chosen with an eye to markets and business segments in which the firm is highly involved. The usefulness of the scenarios is enhanced when they are run at periodic intervals, allowing the firm’s exposure to be tracked over time. Corporate-level stress tests are facilitated by the presence of firm-wide information-technology systems which offer risk managers an up-to-date, usable, accurate source of information on exposures.

Limitations of stress testing

A stress test estimates the exposure to a specified event, but not the probability of such an event occurring. In addition, numerous decisions in the specification of a stress test must be made that rely on the judgment and experience of the risk manager. There is thus no guarantee that the risk manager will choose the “right” scenarios or interpret the results effectively. Stress tests also impose a high computational cost, particularly in collecting the data from diverse business units and from the need to revalue complex options-based positions. A further limitation is that, at present, firms cannot integrate market and credit risks in a systematic way in their stress tests, although some interviewed firms are engaged in efforts in this direction.

Aggregate stress tests

What is an aggregate « stress test » ?

An aggregate stress test is a measure of the risk exposure of a group of reporting firms to a specified stress scenario. Each reporting firm would provide information on its own exposure under the stress scenario. The responses would be aggregated by a central coordinator. The aggregation could produce single number capturing the combined exposure of all reporting firms. In addition, information on the distribution of exposures among firms as well as across markets and risk factors could also be captured.

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