Bank Stress Test Explained

Bank stress test is mainly used in order to ascertain the stability of the given institution, in this aspect, the bank. Bank stress test involves testing the entire banking system beyond its operational capacity to the extreme up to the breaking point in an effort to monitor the results and therefore the overall stability of the bank.

Bank stress test is aimed to measure the robustness of the financial system in scenarious such as system crashes and so on. Bank stress test does not involve financial projections or a best case scenario but on the contrary, focuses on the worst case scenario. The ultimate goal is whether a bank has the required wealth and assets to overcome any adverse developments in the financial markets.

Bank stress tests took prominence as the European and US banking systems were put to test in 2009 and 2010 in the wake of the global financial crisis which took its toll on the general robustness of the financial systems as well.

Bank stress tests are used to identify any weak sposts in the banking system at an early stage. It is used to measure various risks usually faced by a financial institution, which include:

Bank Stress Tests – Credit Risks

Credit risks measures the losses incurred by the banks in the event of any defaults such as consumer/corporate loans, mortgages, non performing loans and so on.

Bank Stress Tests – Market Risks

Market risks measure the impact that happens on a bank in areas such as changes in the currency exchange rates, increase or decrease in interest rates, fluctuating prices of financial assets such as bonds, equities and so on.

Market and Credit risks make up for the critical elements in a bank stress tests as they measure the bank’s profits and solvency.

Bank Stress Tests – Liquidity Risks

Liquidity came into the spotlight after the collapse of Lehman Brothers. Hitherto, banks really didn’t pay much attention on their liquidity, or the available cash in hand. When in 2008 banks were confronted with liquidity risks as part of the bank stress tests, it was shocking to note that the problem of liquidity was more widespread. Based on the results from Liquidity risks, non banking institutions, market participats that were involved in lending to the banks decided to put on hold their lending practices. This left banks in a situation where they could not ask for loans at reasonable interest rates, which led the authorities to develop unconventional methods to inject cash liquidity into the banking institutions.

How a bank reacts in emergency situations based on the worst case scenarious in the main areas mentioned above and acts as a guide to prepare the banks to take any preventive measures which could avert any oversight that can seem unlikely to happen but is plausible.

The bank stress test results are based on the assumptions under various economic scenarios which were developed by the International Monetary Fund (IMF). The bank stress test scenarios are usually termed as ‘unlikely to happen, yet plausible’ Besides the IMF, banks regularly use stress tests in order to manage their risks and in most cases, with the exception of the bank stress tests initiated by the IMF, the results are private.

Limitations of Bank Stress Tests

The main limitations of bank stress tests is that they are only as helpful as the eventualities that the scenarios are drawn upon and how pessimistic the testing scenarios are built upon. Those involved in planning a stress test usually go beyond the imaginative possibilities that the financial institutions could be confronted with. Therefore, due attention must be paid to the the type of scenarios being drawn up and tested with.

[pullquote_left]Bank Stress Tests are only as good as the test planners and their imaginative limitations in drawing upon the various unforeseen economic scenarios.[/pullquote_left]

The biggest obstacle with bank stress tests is obviously the test designer’s failure to take into account the various scenarios and thus potentially leave out some unforeseen eventualities. The stress test designers are usually influenced by peer pressure, group thinking and thus does not leave much room to think out of the box. Such dynamics were best seen when the European Banking Authority and the Panel of European Banking supervisors conducted bank stress tests in 2009, 2010 where the test planners back then believed that a detrimental eventuality of a comparatively mild macro economic environment of a -0.6% commercial expansion into the eurozone area could be ignored. By 2011 it was evident that such kind of guessing was not credible anymore and were bound to happen and thus corrected the undesired eventuality to a -4% expansion.

The above scenario brings to light that stress test planners must be very critical on the eventualities that are built into the test. There is always a baseline eventuality that stress test observers should always make note of as the goal of the stress test is to check the financial institution against all events no matter how benign they might seem under the present circumstances. To conclude, while bank stress tests can be useful to potentially highlight any weak links in the system, they are only as good as the stress test planners.

It is beyond the human means to build a bank stress test system that is 100% foolproof. While bank stress tests can help the institutions correct any mistakes in their systems, it cannot provide complete insulation against any unforeseen economic scenarios. Perhaps one way to counter this shortcoming is to engage banks to conduct stress tests at regular intervals taking into consideration the prevailing and near future economic conditions.