Finance

Bank Stress Test

Bank Stress Test

For almost everyone, recessions and market collapses are painful, and they can be particularly problematic for banks. The global financial crisis in 2008 was considered to be a consequence of sub-optimal stress tests in banks. This further led regulators to drive investment, develop and incorporate improved stress-testing mechanisms globally. Banks normally lend more money than they do, so bank losses are magnified and rippled across the financial system. They use stress tests to predict what will happen when things go wrong in order to avoid a disastrous outcome.

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What is the Bank Stress Test?

A bank stress test is an analysis designed to determine the ability of a bank to deal with an economic crisis. Banks are tested on hypothetical scenarios to determine whether it has enough capital to sustain itself during an economic crisis. Taking into consideration the exposures of banks and market models, the consequences for the financial situation of individual banks in a variety of macroeconomic scenarios are analyzed. It emphasizes certain key areas for assessing the financial health of banks in crisis, such as credit risk, market risk, and liquidity risk. All stress tests include a standard number of scenarios that banks may face. Based on actual financial events in the past, historical examples are also considered. Hypothetical scenarios are developed with computer simulations using various criteria from the Federal Reserve and International Monetary Fund (IMF).

Importance of stress testing?

Stress testing in banks is conducted to alert the management about the adverse effects a bank can face during economic shock and also provides an indication of the financial resources that will be necessary. After the 2008 financial crisis, many financial institutions were undercapitalized. This showed how vulnerable they were to economic crashes. Hence, the importance of stress testing was realized. Stress testing encourages banks to adopt efficient risk mitigation and management procedures. It also helps to establish transparency in the banking system through the enhanced collection of data and publication. In other words, stress testing is no longer seen as a mere compliance activity, but rather as a competitive and lucrative feature.

 

Types of stress tests:

Stress testing includes running simulations to find hidden vulnerabilities.  A bank has to perform stress tests based on its size and on the regulations of 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).

Dodd-Frank Act Stress Testing (DFAST):

Any banks exceeding the 250 billion dollar mark have to fulfill the DFAST criteria by routine company assessments and the reporting of outcomes to the Fed (every year or semiannual, depending on the size of the institution).

Comprehensive Capital Analysis and Review (CCAR): 

The CCAR is conducted in accordance with the DFAST stress test and is much more qualitative than the DFAST, which requires more quantitative measures. Banks with more than $100 billion in assets will need to complete stringent CCAR stress tests. Institutions having more than $250 billion in assets are expected to undergo more rigorous CCAR testing, which could include additional qualitative and quantitative criteria than standard CCAR assessments. It may include an analysis of internal banking strategies and procedures for coping with challenges, planned corporate actions, and much more.

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Bottom line:

Stress testing is very beneficial as it identifies the resources needed for the bank to survive an economic crisis. It helps the bank prepare itself and refrains it from being undercapitalized. The stress tests resulting from banks’ failures during the crisis have led to reducing the burden on the financial system.

 

Author – Abha Shetty

About the author – Abha is a second-year BMS student and FRM level 1 candidate. She is very intrigued by the world of financial markets and hopes to master the art of investing and trading.

 

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