Impact of stress tests on the financial system

Since the end of 2007, when several financial institutions collapsed, stress tests on institutions have increasingly been used in different countries with the aim of assessing their robustness and identifying the source of potential weaknesses that could result in new adverse events capable of leading to financial system contagion.

Stress testing is a series of techniques that attempt to measure portfolio, individual bank or financial system sensitivity to changes in certain risk factors. Broadly defined, this includes tools as diverse as strategic what-if analysis, portfolio assessment under different scenarios and analysis of the solvency and liquidity of financial institutions, among others.

Stress testing has been used by banks for decades as an internal management tool that was closely linked to risk management, planning and budgeting. However, as a result of the international economic situation in the last few years, what was once an internal screening exercise has become a monitoring tool to assess the capital adequacy of institutions in the medium term, and a public instrument of renowned importance. Thus, stress testing is usually conducted as a regulatory requirement aimed at ensuring that institutions have adequate solvency to survive a number of adverse but likely scenarios. Therefore, it can be said that the financial crisis has contributed to the spread and, in many countries, the regulation of the practice of these exercises. This trend responds both to an alignment with international best practices and to prudential behavior in anticipation of potential future crisis scenarios similar to those that have occurred in the more developed economies.

From a regulatory point of view, stress testing was strongly promoted by the Basel Committee on Banking Supervision under Pillar 2 of the Capital Accord known as Basel II, which maintains its structure in Basel III. Under Pillar 2, an Internal Capital Adequacy Assessment Process (ICAAP) and a Supervisory Review and Evaluation Process (SREP) are required to be carried out by the institutions and the supervisor respectively on a regular basis.

This regulatory difference is reflected in financial stress tests; thus, two categories or types of stress tests must be distinguished:

  • Internal stress tests, carried out by each institution, which are governed by the ICAAP provisions in terms of their periodic implementation, but only by some guidelines or principles in terms of their specific execution methodology. Their goal is twofold: to provide a forward-looking approach to be integrated in strategic and business decision making, and to inform the supervisor about capital planning under different scenarios.
  • Supervisory stress tests, conducted by supervisory authorities, national and international regulators and banking associations; regulated in part by the provisions of the SREP (Supervisory Review And Evaluation Process); focused on specific aspects of the solvency and liquidity position of institutions and the financial system as a whole. Their aim is to diagnose and occasionally strengthen the stability of the system by taking measures such as the recapitalization or winding-up of institutions whose results are not satisfactory.

Basel’s regulatory requirements regarding both types of stress tests have rapidly been adopted by many national supervisory and regulatory authorities and supranational bodies (such as the EBA or the IMF). In every case, these bodies have gone beyond the established minimum requirements and have set their own standards towards establishing best practices in the financial industry.

Concerning the internal stress tests, it is evident that beyond regulatory requirements stress testing as a management tool offers a broad range of uses that more and more institutions are incorporating into their decision-making process, especially in regards to risk appetite definition and monitoring. This management approach, which in many institutions preceded the regulatory approach, is being enhanced by the stress tests required by the ICAAP, and in many institutions it is in line with them.

As for the supervisory stress tests, despite the growing regulation and beyond the seriousness of the macroeconomic scenarios used and the assessments received from organizations which try to unify practices, neither an international standard nor a benchmark of the different exercises have been observed yet. Moreover, analysis on the degree of accuracy of their predictions has barely been observed, neither in terms of the macroeconomic projections nor of the profit and loss accounts and solvency of the institutions under stress scenarios.

In this context, this study aims to provide an overview of stress tests, their nature and their implications for financial institutions. To do so, this paper has three basic goals which are developed over three sections as follows:

  • Description of internal stress testing by financial institutions, its regulation in several representative countries, main uses in management and key methodological aspects.
  • Analysis of supervisory stress testing by some of the main supranational and national bodies, looking into the description, the impacts and the implications of several tests carried out on financial institutions in recent years, as well as the challenges and unresolved issues that remain.
  • Retrospective analysis of a supervisory exercise through a quantitative empirical exercise (a backtest of the stress test), towards assessing the degree of accuracy both in the macroeconomic scenarios used and in the losses and capital expected. The exercise carried out by the EBA in 2011 and, more specifically, the homogeneous analysis sample composed of the 22 participating Spanish institutions, was selected for this purpose. 

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