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What Is a Bank Stress Test?

U.S. Federal Reserve: one of the bank supervisors that have conducted stress tests to identify risks in banking systems (photo: Joseph Sohm)

BANK STRESS TESTS

What Is a Bank Stress Test?

IMF Survey online

July 29, 2010

  • Unlikely but plausible scenarios identify risks
  • IMF stress tests countries’ banking systems
  • New techniques being developed

What if unemployment skyrocketed and economic growth ground to a halt?  How would banks fare?

Banks and government officials charged with overseeing banking systems try to answer these types of questions by performing stress tests—subjecting banks to “unlikely but plausible” scenarios designed to determine whether an institution has enough net wealth—capital—to weather the impact of such adverse developments.

Stress tests of banking systems in Europe in 2010 and the United States in 2009 have generated considerable interest given the impact of the global crisis on the health of the financial system as a whole.

Stress tests are meant to find weak spots in the banking system at an early stage, and to guide preventive actions by banks and those charged with their oversight.

Stress test results depend on how pessimistic the scenarios’ assumptions are, and should be interpreted in light of the assumptions made.

In the wake of the 2008 failure of investment bank Lehman Brothers, and of the worst global financial and economic crisis in 80 years, those who design stress tests are taking a long, hard look at what constitutes “unlikely but plausible” scenarios.

Different tests, different purposes

There are many different types of stress tests, with different uses. Some are carried out by banks themselves to help manage their own risks. Some are done by supervisors as part of their ongoing oversight of individual banks and banking systems. Many of these tests are never published.

The IMF has been using stress tests extensively in the last decade to assess the ability of banking systems to withstand major adverse developments. Indeed, virtually all of the Fund’s Financial System Stability Assessment reports include stress tests of banking systems.

There is one thing that almost all stress tests have in common. They are typically carried out to shed more light on a few key types of threats to banks’ financial health: credit and market risk, and most recently, liquidity risk, a problem that reared up during the global crisis.

Credit and market risks

Credit and market risks are key because they affect banks’ profits and solvency.

Credit risks reflect potential losses from defaults on the loans a bank makes, including consumer loans, such as mortgages, and corporate loans. Stress tests for credit risk examine the impact of rising loan defaults, or non-performing loans, on bank profit and capital.

Market risk stress tests gauge how changes in exchange rates, interest rates, and the prices of various financial assets, such as equities and bonds, affect the value of the assets in a bank’s portfolio, as well as its profits and capital. Typically, the test would assume a drop in the value of the various assets in the bank’s portfolio.

The changes in asset prices and default rates are often linked to a negative economic scenario in which, among other things, unemployment climbs and economic growth plummets. Such tests are called macro stress tests, as economic assumptions are used to project by how much a bank’s non-performing loans may increase or how much a bank would bear losses from lower asset prices in its portfolio.

The United States and European authorities chose this approach in their recent stress tests. One benefit of macro stress tests is they communicate more clearly the underlying assumptions. One downside is that the scenarios are more difficult to build and the results are subject to modeling uncertainty, since there is no standard way to link the economic assumptions to default rates or asset prices.

Liquidity risk

Before the Lehman Brothers collapse, many bank supervisors did not worry too much about how much liquidity—or cash on hand—banks had. As long as a bank was healthy and solvent and could manage regular cash flows, it was seen as unlikely to fall short of cash--and even if it did, it would be able to find cash easily, either by borrowing money from other banks or by selling assets. Deposit insurance could also help to prevent bank runs for fundamentally healthy banks.

All advanced economies have some rules and guidance for banks on liquidity risk management, but the liquidity shocks banks were confronted with in 2008 turned out to be much more widespread and severe than banks and regulators anticipated. Compounding the problem, various other types of non-bank financial institutions that distribute liquidity in the system, such as money market funds, and money market participants more generally, stopped lending to banks.

Many banks found themselves unable to borrow money at reasonable interest rates or get enough cash by selling assets, as many asset prices had collapsed. As a result, authorities had to develop unorthodox ways to inject massive amounts of cash into liquidity-strapped institutions.

Liquidity stress tests generally used before the crisis focused on the impact of deposit withdrawals or on the inability of a bank to refinance, which could be triggered, for instance, by a credit downgrade of the institution.

These turned out to be insufficient to simulate the range of potential liquidity shortages. Recently, efforts to develop more adequate tools have intensified. For example, the Basel committee, which is made up of central bankers and regulators from most members of the G-20 group of advanced and emerging economies, is now focusing on liquidity risk and debating a number of different proposals to address liquidity issues.

New frontiers in stress testing

The global economic crisis has also highlighted the importance of expanding the scope of stress tests beyond the individual risks to banks, to system-wide risks.

Efforts are underway by national supervisors as well as international organizations involved in financial stability, such as the IMF and the Bank of International Settlements, to develop new risk-modeling techniques and stress test methodologies to better identify the risks that trigger widespread economic and financial instability.

One of the risks to identify is the connection between individual financial institutions, and the potential that problems affecting one bank, or a group of banks, may propagate to other institutions and potentially threaten the stability of the financial system as a whole.

Stress tests will also need to take into account the global scale of banks operations, which have the potential to transmit shocks from one country to another on a scale previously unheard of, as seen recently in foreign exchange funding or structured credit and credit derivatives markets.

One of the lessons of the recent crisis is the need to understand and assess the interplay between the financial sector and economic stability. Sophisticated approaches are needed to examine the impact of economic shocks on financial institutions' asset portfolios, as well as the subsequent effects of financial institutions’ distress on the economy, which can continue to feed off one another if not contained.

As stress tests remain at the forefront of the ongoing debate about how to improve the health of the global financial system, banks, regulators and supervisors will continue to develop them as tool for spotting emerging risks, and financial markets will be paying attention to the results.


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