Back to Basics: What Is Stress Testing?
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Bibliographic details
- Authors: MARTIN CIHAK, HIROKO OURA, LILIANA SCHUMACHER
- Published: September 1, 2019
Overview
- Purpose: Check the health of banks and broader financial stability by answering questions such as whether banks can survive large borrower defaults or catastrophic natural disasters.
- Historical drivers:
- Attention to stress testing surged during the 2008 global financial crisis when banks and other financial firms lost vast sums of money and some institutions failed or required multibillion-dollar taxpayer-funded bailouts.
- The IMF adopted stress testing in response to the Asian financial crisis of 1997 and included stress tests in the Financial Sector Assessment Program run jointly with the World Bank since 1999.
What stress tests typically cover
- Core dimensions:
- Solvency: whether banks have enough capital to absorb losses.
- Liquidity: whether banks have enough cash to pay out deposits and other debts.
- Illustrative numerical examples from the explainer:
- If a bank loses $1 billion when house prices drop by 50 percent, the bank can survive if its capital is $10 billion but not if it is $1 billion.
- If depositors suddenly withdraw $50 million and the bank cannot borrow to replace those deposits, the bank can survive if it owns assets, such as government bonds, that it can sell quickly.
Scenario design and application
- Key ingredient: an adverse scenario that is severe yet plausible.
- Severe scenario: a low-probability event with potentially catastrophic consequences (examples provided: a once-in-a-century earthquake, a repeat of the 2008 financial crisis, or a government debt default).
- Plausibility excludes absurd hypotheticals (example given: a Martian invasion).
- Historical scenarios are useful but may not capture novel risks (examples of novel risks: new financial technology, climate change).
- Scenario construction steps:
- Start with a list of potential country-specific risks (example risks: a major decline in manufacturing for an economy reliant on factory production; a terrorist attack in a country dependent on tourism).
- Develop a storyline for the scenario and estimate how macro variables such as GDP and interest rates react.
- Gauge how bank clients would behave under the scenario (estimate how many households and companies would continue paying debts and how deposit behavior would change).
- Translate client behavior into effects on banks’ liquidity and capital.
Transmission, contagion, and economic impact
- Interconnectedness: failures of some banks can ripple through the financial system and damage the broader economy.
- Examples of knock-on effects:
- If banks stop lending, companies may shrink operations and lay off employees.
- Lack of mortgage lending could prevent families from buying homes.
Emerging risks and expanding scope
- Growing coverage: stress tests increasingly cover mutual funds, insurance companies, and other nonbank service providers, as well as novel sources of risk (for example, new financial technologies).
- Specific emerging challenges highlighted:
- New financial technologies could squeeze profits of existing financial service firms.
- Banks’ growing dependence on third parties for services such as cloud computing raises new stress-testing challenges.
- Climate change introduces two types of risk:
- Physical risk: increasing frequency and intensity of floods, droughts, and other natural disasters—insurers selling building and disaster insurance could lose money or raise premiums to unaffordable levels for many households.
- Transitional risk: policy or market-driven declines in sectors such as coal in response to measures like a carbon tax—resulting corporate losses, loan defaults, and losses on bonds and equities issued by these firms.
IMF approach and objectives
- Distinctive focus: IMF stress tests emphasize the financial system as a whole rather than concentrating solely on individual institutions.
- Use in policy: IMF assessments identify risks and recommend ways national authorities can reduce risks before they materialize and control damage if they occur.
- Contrast with some national stress tests: when the 2008 crisis struck, authorities in the United States, the euro area, and elsewhere adopted stress tests with a main focus on identifying weaknesses in individual banks and considering measures to restore or close them; some of these tests were made public to bolster confidence.
Data, limitations, and complementarities
- Data requirements: stress tests must employ reliable, timely, and detailed data, including historical data covering turbulent episodes as well as calm periods.
- Risks of poor data: incomplete or inaccurate data yield unreliable results and may provide a false sense of comfort.
- Complementary tools: stress tests are not stand-alone—full-fledged risk analysis should combine stress tests with other quantitative and qualitative tools and be complemented by examination of financial sector policies, oversight frameworks, and financial safety nets (example: the existence and scope of deposit insurance).
- When integrated into a comprehensive, in-depth assessment, stress tests are described as “quite powerful.”
Source: Back to Basics: What is Stress Testing? – IMF F&D
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