Bank Stress Test

What is the definition of a Bank Stress Test?

Definition

Bank stress refers to the exercise carried out by bank managers and regulators to measure a bank’s financial strength during economic downturns such as recessions and financial market crashes. It is a tool used to analyze a bank’s capacity to withstand an economic crisis using a computer-stimulated model or economic scenario. In the occurrence of an economic downturn, banks tend to suffer as well, as they are required to lend more money in contrast to what they have on the ground. Thereby, creating an economic ripple if the banks suffer large losses. To avoid such an economic occurrence, banks carry out a bank stress test to measure the possibilities of catastrophic results and predict the worst of situations.

Understanding the Bank Stress Test

After the global financial crisis of 2007 -2009, the bank stress test was implemented in many banks as many banks were already victims of undercapitalization and vulnerable to economic downturns. Due to this, financial reporting requirements were expanded by the federal and financial authorities to ensure accuracy in capital management.

In carrying out a bank stress test, the following key areas are considered:

• Credit risk

• Market risk

• Liquidity risk

With the help of a simulation model, an economic scenario is created and the possible crises are tested in the scenario to see how the model reacts to them. These crises are created based on certain criteria gotten from the Federal Reserve and International Monetary Fund (IMF).  The bank stress test requires that all possible crisis scenarios be tested out from the worst scenarios to the less likely scenarios. Some banks go-ahead to conduct an internal bank stress test to double-check their numbers.