Stress testing has been a much-favoured simulation technique used by
banks to evaluate the risk of having insufficient capital during tough times.
Large financial institutes have been using stress tests as a form of scenario
analysis ever since the early 1990s. They have become increasingly
popular, however, after the worldwide financial crisis that took place
between 2007 and 2009, and has proven to be a fruitful endeavour when it
comes to preventing undercapitalization in financial institutes.

Stress Testing Methodology
Focusing on critical risks like credit risk, market risk and liquidity risk, stress
tests analyze the ability of a financial institution to withstand crisis situations
in hypothetical scenarios. These scenarios are simulated using complex
computer software and the subject of evaluation is always the bank’s
balance sheet. The test is used to study the sensitivity of a bank when it is
put through harsh economic changes. The stresses applied can be scaled
from light to severe to produce dynamic results and to see how the bank
performs under varying conditions. Factors to consider for stress testing are as below:

• Capital
• Risk Type
• Model Design
• Infrastructure
• Coverage

Types of Stress Tests
Stress tests were typically performed by financial institutions themselves as
a form of self-evaluation but beginning in 2007, regulatory bodies decided
that it was necessary to conduct their own stress tests in order to ensure
that banks can operate effectively.

Bank Stress Tests: These are bank-run tests that are conducted
frequently (usually semi-annually). They go through strict reporting
deadlines. The first report needs to be delivered to the Federal
Reserve by the 5th of January while the second needs to be delivered
by the 5th of July.

Federal Reserve Stress Tests: The Federal Reserve itself is
required to run annual stress tests on financial institutions that have
$50 billion or more in current assets. This test is referred to as the
Dodd-Frank Act Stress Test as it was a result of the passing of the
bill of the same name in 2010.

Benefits of Stress Testing in Banks
A. Post Stress Capital – Since the initial adoption of the Dodd-Frank Act
Stress Test the Federal Reserve has discovered that post-stress
capital has generally increased. Due to results like this, the reserve is
looking to simulate more complex scenarios in the near future.

B. Public Awareness – Banks that undergo stress testing are required to
release the results of the tests to the general public. This means that
customers can research and be cautious of how their bank would
perform under major crises.

C. Bank Preparation – Using stress tests, banks can spot their
weakness and amend them. If an actual economic disaster does
arrive, the bank can then be prepared to face it.

D. Preventing Further Difficulties – Thanks to new regulations, financial
institutions that fail the stress tests will have to cut their share
buybacks and dividend payouts. This will allow the bank to preserve
capital and prevent further financial challenges.