What is stress testing? Definition and meaning

Stress testing is a simulation or analysis designed to find out how resilient a financial instrument, investment portfolio, financial institution, or whole economy is at dealing with extreme situations and economic crises. Stress testing may also refer to tests that measure how well a company or industry might fare when exposed to certain stressors.

Stress testing typically involves using customized computer-generated simulation models that expose whatever is being tested to hypothetical scenarios.

In IT (information technology), stress testing is a process that determines how effective a computer, program, network, website or device remains under unfavorable conditions. It may consist of quantitative tests, carried out in a lab, such as measuring the frequency of system crashes or errors.

The Financial Times’ glossary of terms says the following regarding stress tests:

“These are attempts to gauge the health of banks by running disaster scenarios and seeing if they survive. Ever since banks collapsed – many of them due to a lack of liquidity, regulators have been running regular six-monthly tests on their big banks.”

“The irony is that they focus not on liquidity stress but on capital stress. In other words, whether a bank is solvent rather than whether it has financing to operate day to day.”

Portfolio stress testing
In this retirement portfolio, 50% is invested in a security that tracked the S&P 500 Index and 50% in security that tracked the US investment-grade bond markets. As you can see, an oil price rise could reduce your investment by as much as as 4.5%. Market Watch says: “You might consider reducing your stake in investments that don’t perform well when oil prices rise. Or, you might just keep an eye on oil prices and adjust your portfolio if and when necessary.” (Image: adapted from ei.marketwatch.com)

Stress testing portfolios

Stress tests allow portfolio managers to understand how sensitive their investment portfolios are to unfavorable scenarios or significant economic change, and the implications for regulatory compliance, capital allocation, and provisioning.

**Basel II and III, which focuses on the banking sector, mandates certain portfolio stress tests alongside specific guidelines for capital approaches.

** The Basel Accords – Basel I, II and III – are a set of banking regulation recommendations created by the BCBS (Basel Committee on Banking Supervision). BCBS was set up by the Group of Ten countries in 1974.

According to Experian plc, a global information services group:

“When developing methodologies for stress testing, it is vital to ensure that any program adequately addresses a range of economic scenarios for both regulatory and managerial purposes.”

Stress testing banks

Known as the bank stress test – this test exposes banks to unfavorable economic scenarios to see whether they have enough capital to withstand the adverse shocks.

Until 2007, bank stress tests were typically performed only by the financial institutions themselves, for internal self-assessment.

Stress Testing - banks
Since that last global financial crisis, banking authorities in the advanced economies and many emerging ones have made it mandatory for their major banks to undergo annual or six-monthly stress testing to determine how they might cope in severely adverse scenarios.

During the 2007/8 global financial crisis, governmental regulatory bodies in the advanced economies became interested in carrying out their own stress tests to make sure their financial institutions could withstand future major economic and financial shocks.

Since the global financial crisis, stress testing has been routinely performed by financial regulators in countries and regions across the world.

In the United States, for example, financial institutions with $50 billion in assets have to undergo go stress tests from the Federal Reserve, as well as those carried out by their own risk management team.

Bank stress testing focuses on:

Market Risk: this test gauges how changes in interest rates, the prices of equities and bonds and other financial assets, and exchange rates affect the value of the assets in a financial institution’s portfolio, as well as its capital and profits.

Credit Risk: the test reflects potential losses on loan defaults, including mortgages and other consumer loans, as well as corporate loans. Stress testing for credit risk determines what the impact of rising non-performing loans (loan defaults) might be on bank profit and capital. Defaults occur when borrowers cannot pay back their debts.

Liquidity Risk: looks at the cash on hand that the banks have. Before the Lehman Brothers collapse, bank supervisors were not too bothered about how much cash on hand – liquidity – banks had. During the last global financial crisis, many banks were simply unable get enough cash by selling assets because many asset prices had completely collapsed – they could not borrow money at reasonable interest rates either.

Consequently, the authorities had to think up unorthodox ways to inject colossal amounts of cash into liquidity-starved institutions. Stress testing showed that these measures taken by the government were insufficient. More adequate simulation tools have intensified.

Stress testing aims to find weak spots in the banking system at an early stage. If it manages to do that, banks can take action and be better prepared.

In an article – ‘IMF Survey: What Is a Bank Stress Test?’ – the IMF (International Monetary Fund) writes:

“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.”

Timothy Geithner - Stress testing quote
Timothy Franz Geithner was the United States’ 75th Secretary of the Treasury from 2009 to 2013 under President Barack Obama. From 2003 to 2009 her was President of the Federal Reserve Bank of New York. He is currently President of private equity firm Warbug Pincus. ‘Stress Test: Reflections on Financial Crises‘ is a memoir of his time as Secretary to the Treasury; it was published in 2014. (Image: treasury.gov)

In its 2017 stress testing guidelines, the Bank of England says it now has two scenarios. Alongside the annual cyclical scenario – Scenario 1: Economic Shock – the UK’s central bank is, for the first time, running an additional exploratory scenario – Scenario 2 – Long-Term Challenges.

Regarding the publication of the bank stress testing results, the Bank of England writes:

“Given the focus of the BES is to examine structural challenges in the market and banks’ responses to them, the Bank’s analysis will consider the impact of these challenges on the sector.”

“To that end, the results publication will disclose aggregate results, including coverage of the economic impact of any strategic decisions banks make, and analysis on the implications for the future resilience of the banking sector.”

“The Bank does not intend to publish individual bank results under the BES, based on considerations around the possible commercial sensitivity of the projections banks will provide.”

The US Federal Reserve’s stress testing results, published in 2016, in which thirty-three banks participated, had a ‘severely adverse’ scenario where those banks suffered loan losses totaling $385 billion. This scenario featured a severe global recession with US unemployment increasing by five percentage points, accompanied by negative yields for short-term Treasury securities, and a heightened period of financial stress.

Daniel K. Tarullo, who has been a member of the Board of Governors of the Federal Reserve Board since January, 2009, said regarding the latest tests:

“The changes we make in each year’s stress scenarios allow supervisors, investors, and the public to assess the resiliency of the banking firms in different adverse economic circumstances.”

“This feature is key to a sound stress testing regime, since the nature of possible future stress episodes is inherently uncertain.”

Video – What is stress testing

This Bank of England video explains what stress testing is, why it is necessary, and what the UK central bank’s approach is regarding testing the country’s financial institutions.