What Is a Bank Stress Test?

Unlikely but plausible scenarios identify risks

IMF stress tests countries’ banking systems

New techniques being developed

Banks and government officials charged with overseeing banking systems try to answer these types of questions by performing stress tests—subjecting banks to “unlikely but plausible” scenarios designed to determine whether an institution has enough net wealth—capital—to weather the impact of such adverse developments.

Stress tests of banking systems in Europe in 2010 and the United States in 2009 have generated considerable interest given the impact of the global crisis on the health of the financial system as a whole.

Stress tests are meant to find weak spots in the banking system at an early stage, and to guide preventive actions by banks and those charged with their oversight.

Stress test results depend on how pessimistic the scenarios’ assumptions are, and should be interpreted in light of the assumptions made.

In the wake of the 2008 failure of investment bank Lehman Brothers, and of the worst global financial and economic crisis in 80 years, those who design stress tests are taking a long, hard look at what constitutes “unlikely but plausible” scenarios.

Different tests, different purposes

There are many different types of stress tests, with different uses. Some are carried out by banks themselves to help manage their own risks. Some are done by supervisors as part of their ongoing oversight of individual banks and banking systems. Many of these tests are never published.

The IMF has been using stress tests extensively in the last decade to assess the ability of banking systems to withstand major adverse developments. Indeed, virtually all of the Fund’s Financial System Stability Assessment reports include stress tests of banking systems.

There is one thing that almost all stress tests have in common. They are typically carried out to shed more light on a few key types of threats to banks’ financial health: credit and market risk, and most recently, liquidity risk, a problem that reared up during the global crisis.

Credit and market risks

Credit and market risks are key because they affect banks’ profits and solvency.

Credit risks reflect potential losses from defaults on the loans a bank makes, including consumer loans, such as mortgages, and corporate loans. Stress tests for credit risk examine the impact of rising loan defaults, or non-performing loans, on bank profit and capital.

Market risk stress...