Banks on the Treadmill

• Author: Hiroko Oura and Liliana Schumacher
• Position: and are Senior Economts in the IMF's Monetary and Capital Markets Department.

A visit to a cardiologist often includes a stress test. Monitoring routine activities is not enough to determine a patient’s health; the doctor makes the patient walk or run on a treadmill or pedal a stationary bike until he or she is out of breath, because some heart problems are easier to diagnose when the heart is working harder and beating faster. The patient may not have any signs or symptoms of disease when at rest, but the heart has to work harder during exercise and therefore requires more blood and oxygen. If the heart indicates that it is not getting enough blood or oxygen, then this can help the doctor identify potential problems.

Something similar occurs when economists conduct stress tests on banks, which are key to the functioning of the economy. The goal of the tests is to find and fix any banks with problems, to reduce the chance of a banking crisis. A banking crisis—when several banks become insolvent or are unable to make payments on time—disrupts the economy by limiting access to long-term loans or liquidity needed for production and distribution of goods and services. This, in turn, affects growth, employment, and—in the end—people’s livelihoods.

To minimize the risk of a disruptive banking crisis, bank vulnerabilities need to be found while there is still time to correct them. But, as in the case of the human heart, vulnerabilities of financial institutions may not be visible by just looking at past performance when the economy is running smoothly and there are no overwhelming problems. To assess banks’ health properly, stress tests perform hypothetical exercises to measure the performance of banks under extreme macroeconomic and financial scenarios—such as a severe recession or a drying up of funding markets.

Stress tests typically evaluate two aspects of a bank’s condition, solvency and liquidity, because problems with either could cause high losses and eventually a banking crisis.

Solvency is measured by the difference between an institution’s assets and its debt. If the value of an institution’s assets exceeds its debt, the institution is solvent—that is, it has positive equity capital (see table). But the ongoing value of both assets and liabilities depends on future cash flows, which, in turn, depend on future economic and financial conditions. For an institution to be solvent, it has to maintain a minimum amount of positive equity capital that can absorb losses in the event of a shock, such as a recession, that causes customers to fall behind on loan repayment. And capital even beyond this minimum might be needed to ensure the continued confidence of the bank’s funding sources (such as depositors or wholesale investors) and access to funding at a reasonable cost.

A solvency stress test assesses whether the firm has sufficient capital to remain solvent in a hypothetically challenging macroeconomic and financial environment. It estimates the bank’s profit, losses, and changes in the value of the bank’s assets under the adverse scenario. Typical risk factors are potential losses from borrowers’ default (credit risk); losses from securities due to changes in market prices...