A bank stress test determines how well a bank might withstand an economic crisis such as the one that struck the world in 2008 – through an analysis or simulation of potentially catastrophic events.
The tests evaluate whether a bank has enough capital to endure the effects of bad economic developments. It also looks at staff training, i.e. do they know what to do if another crisis strikes?
Bank stress tests are carried out internally (by the banks themselves) and also by regulatory bodies that oversee the banking industry, such as the UK Financial Services Authority, the European Banking Authority, the US Federal Reserve, and the International Monetary Fund.
What kind of scenarios do bank tests typically include?
Examples of the stresses that may be included in a bank stress test include the following:
- What would happen if the US GDP dropped by 5 percent?
- What would happen if interest rates increased by 2 percent?
- What would happen if gold prices declined by 50%?
- What would happen if gas prices rose by 250%?
List of bank stress tests
Monetary Authority of Singapore – the Annual Industry-Wide Stress Testing exercise
International Monetary Fund – Financial System Stability Assessment Update (FSAP)
China Banking Regulatory Commission – CARPLES risk indicators framework
Financial Services Authority – Stress and Scenario Testing
European Banking Authority – European Union bank stress test
Federal Reserve System – Comprehensive Capital Analysis and Review (CCAR)
In December 2014, the Bank of England’s annual bank stress test was passed by all UK institutions with the exception of the Co-operative bank.
BoE Governor Mark Carney, although pleased with the results, warned:
“However, recent misconduct and operational failings have highlighted that rebuilding confidence in the banking system requires more than financial resilience. In addition, changes to bank business models are expected to challenge management capacity over the next few years. In this environment, strong, effective and well-informed governance and management of banks will be essential.”
In October 2015, the Bank of England said its stress test would focus on the country’s major retail banks.
Video – The importance of bank stress tests
Paul Tucker, Harvard Kennedy School of Government talks about how bank supervision has been opaque to the public. He explains how results of an annual stress test can transform the accountability of the Federal Reserve and other central banks.
Recent developments related to bank stress tests
A 2014 report by PwC titled Passing the stress test, concluded that banks need to take on more staff. Most of the banks surveyed said that more investment was necessary, as only 13% reported already having sufficient, suitably skilled staff to carry out regulatory stress testing.
Richard Barfield, a director at PwC, said the following about bank stress tests:
“The way banks carry out regulatory stress tests is becoming more critical, simply because of their power to set capital buffer levels, determine management actions and restrict dividends and employee bonuses. Stress testing sits squarely on the agenda of CEOs.”
The European Banking Authority (EBA) announced in October 2014 that 24 banks failed stress tests. The EBA gave them nine months to improve their finances or risk being closed down.
The tests showed that EU banks’ CET1 (common equity ratio) fell from 11.1% at the beginning of the exercise to 8.5% after the end.
“By disclosing these results, the EBA is providing unparalleled transparency into EU banks’ balance sheets, with up to 12,000 data points per bank, an essential step towards enhancing market discipline in the EU.”