Stress Testing used by Financial Institutions

In this article, Jayati WALIA (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022) introduces the concept of Stress testing used by financial institutions to estimate the impact of extraordinary market conditions characterized by a high level of volatility like stock market crashes.

Introduction

Asset price movements in financial markets are based on several local or global factors which can include economic developments, risk aversion, asset-specific financial information amongst others. These movements may lead to adverse situations which can cause unpredicted losses to financial institutions. Since the financial crisis of 2008, the need for resilience of financial institutions against market shocks has been exemplified, and regulators around the world have implemented strict measures to ensure financial stability and stress testing has become an imperative part of those measures.

Stress testing techniques were applied in the 1990s by most large international banks. In 1996, the need for stress testing by financial institutions was highlighted by the Basel Committee on Banking Supervision (BCBS) in its regulation recommendations (Basel Capital Accord). Following the 2008 financial crisis, focus on stress testing to ensure adequate capital requirements was further enhanced under the Dodd-Frank Wall Street reform Act (2010) in the United States.

Financial institutions use stress testing as a tool to assess the susceptibility of their portfolios to potential adverse market conditions and protect the capital thus ensuring stability. Institutions create extreme scenarios based on historical, hypothetical, or simulated macro-economic and financial information to measure the potential losses on their investments. These scenarios can incorporate single market variable (such as asset prices or interest rates) or a group of risk factors (such as asset correlations and volatilities).

Thus, stress tests are done using statistical models to simulate returns based on portfolio behavior under exceptional circumstances that help in gauging the asset quality and different risks including market risk, credit risk and liquidity risk. By using the results of the stress tests, the institutions evaluate the quality of their processes and implement further controls or measures required to strengthen them. They can also be prepared to use different hedging strategies to mitigate the potential losses in case of an adverse event.

Types of Stress testing

Stress testing can be based on different sets of information incorporated in the tests. These sets of information can be of two types: historical stress testing and hypothetical stress testing.

Historical stress testing

In this approach, market risk factors are analyzed using historical information to run the stress tests which can include incorporating information from previous crisis episodes in order to measure potential losses the portfolio may incur in case a similar situation reoccurs. For example, the downfall in S&P500 (approximately 30% during February 2020-March 2020) due to the Covid pandemic could be used to gauge future downsides if any such event occurs again. A drawback of this approach is that historical returns alone may not provide sufficient information about the likelihood of abnormal but plausible market events.

The extreme value theory can be used for calculation of VaR especially for stress testing. considers the distribution of extreme returns instead of all returns i.e., extreme price movements observed during usual periods (which correspond to the normal functioning of markets) and during highly volatile periods (which correspond to financial crises). Thus, these extreme values cover almost all market conditions ranging from the usual environments to periods of financial crises which are the focus of stress testing.

Hypothetical stress testing

In this method, hypothetical scenarios are constructed in order to measure the vulnerability of portfolios to different risk factors. Simulation techniques are implemented to anticipate scenarios that may incur extreme losses for the portfolios. For example, institutions may run a stress test to determine the impact of a decline of 3% in the GDP (Gross Domestic Product) of a country on their fixed income portfolio based in that country. However, a drawback of this approach is estimating the likelihood of the generated hypothetical scenario since there is no evidence to back the possibility of it ever happening.

EBA Regulations

In order to ensure the disciplined functioning and stability of the financial system in the EU, the European Banking Authority (EBA) facilitates the EU-wide stress tests in cooperation with European Central Bank (ECB), the European Systemic Risk Board (ESRB), the European Commission (EC) and the Competent Authorities (CAs) from all relevant national jurisdictions. These stress tests are conducted every 2 years and include the largest banks supervised directly by the ECB. The scenarios, key assumptions and guidelines implemented in the stress tests are jointly developed by EBA, ESRB, ECB and the European Commission and the individual and aggregated results are published by the EBA.

The purpose of this EU-wide stress testing is to assess how well banks are able to cope with potentially adverse economic and financial shocks. The stress test results help to identify banks’ vulnerabilities and address them through informed supervisory decisions.