In financial markets, a stress test is used to calculate the risk tolerance of financial institutions under extreme market conditions. These tests include scenario analysis and sensitivity analysis. The 2023 stress test conducted by the Federal Reserve Bank was based on an increase in unemployment to 10% and a decrease in GDP of -6.5%. It used data from individual banks to test capital sufficiency ratios. At the core of these tests, big banks demonstrated higher capital adequacy ratios, with the last stress test ahead by 9%, showing their ability to withstand economic slumps. Stress tests help quantify risks, enhance market transparency, and strengthen the resilience of financial institutions.
Definition of Stress Testing
Stress testing is a financial analysis tool used to assess the health and resilience of banks, asset managers, or finance solvency under dire economic situations. The test commonly runs hypothetical “what-if” scenarios, such as economic recessions, market crashes, or rapid changes in interest rates. This allows financial institutions to identify potential downfalls in their portfolios and possibly act pre-emptively.
In the wake of the 2008 financial crisis, regulators at the Federal Reserve now require periodic stress tests by big banks to model a range of worst-case economic scenarios and ensure those institutions have enough extra capital on hand. The U.S. 2020 stress test scenarios, as per the Federal Reserve Comprehensive Capital Analysis and Review (CCAR) report, included unemployment increasing to 10.75%, a stock market crash of -50%, and a house price collapse of -30%. By examining such extreme scenarios, financial institutions can evaluate their capital positions and liquidity performance under severe conditions.
Functions of Stress Testing
Risk Identification: Stress tests help identify assets in a portfolio that can lose value under extreme market conditions. In its most recent stress test in 2018, Deutsche Bank highlighted significant high-risk exposure among commercial real estate loans, leading the bank to recalibrate how it originates such credit to avoid large losses.
Enhanced robustness: Stress tests allow financial institutions to determine the amount of capital they should hold to continue operating safely under stress. The European Central Bank (ECB) concluded that the capital adequacy ratio of Eurozone banks dropped from 14.5% to 9.9% following extreme economic downturn scenarios in its recent stress test for 2019.
Regulatory Requirements: Financial regulators in many countries require banks and their subsidiaries to conduct stress tests as part of the regulatory review process. The Dodd-Frank Act mandates annual stress tests for U.S. banks with more than $100 billion in assets to ensure they can withstand recurring business downturns.
Investor Confidence: The results of bank stress tests are also used to assess the financial perspectives of banks by investors. Transparent and effective stress tests can increase investors’ confidence in financial institutions. JPMorgan Chase cleared their stress test in 2019, indicating they have the capital to survive an economic dip, which boosted investor confidence and led to a 3% increase in their stock price following the stress test results.
Methods of Stress Testing
Scenario Analysis: This approach tests the financial conditions of an institution by establishing hypothetical scenarios. This method generally involves changes in variables like GDP growth, unemployment rates, and inflation rates. In its annual stress test, the Bank of England built in a 4.7% fall in GDP and assumed unemployment would climb to 9.2% before estimating how these changes would affect banks’ balance sheets.
Sensitivity Analysis: Sensitivity analysis determines how different investment variables affect themselves over time within an investment portfolio. These changes can be seen in the portfolio’s value by modifying interest rates, exchange rates, or stock market volatility. In 2018, Goldman Sachs conducted a sensitivity analysis on the change of interest rates connected to their fixed-income portfolio, finding that a 100 basis point increase would reduce net income by approximately 5%.
Extreme Events Analysis: This refers to simulating rare but significant events such as financial crises, natural disasters, or political turmoil. This analysis allows banks and other financial institutions to assess their risk exposure and determine the steps they may need to take if conditions worsen. For example, in the latest round of stress tests, Barclays Bank modeled a 2008 financial crisis-style catastrophe where market liquidity vanished and credit spreads widened significantly.
