What Is Stress Testing?

Author:Martin Cihák - Hiroko Oura - and Liliana Schumacher
Position:MARTIN CIHÁK is a division chief,HIROKO OURA is a deputy division chief,and LILIANA SCHUMACHER is a senior economist,all in the IMF's Monetary and Capital Markets Department.
Pages:52-53
SUMMARY

Checking the health of banks is crucial to financial stability

 
FREE EXCERPT
52 FINANCE & DEVELOPMENT | September 2019
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What Is Stress Testing?
Checking the health of banks is crucial to financial stability
Martin Čihák, Hiroko Oura, and Liliana Schumacher
ART: ISTOCK / RASTUDIO
HOW DO WE
KNOW
if a nancial s ystem is healthy?
Can banks survive a recession if ha lf of their
mortgage clients lose their jobs a nd stop paying
their debts? Do insurers have enough money to
pay out claims if a magn itude 8 earthquake hits
Tokyo? Answers to these types of quest ions lie
in stress tests.
Attention to stress testing shot up during t he
2008 global na ncial crisis, when banks and other
nancial rms lost vast sums of money. Major
long-est ablished instit utions— such a s Lehm an
Brothers—went belly-up. Others requ ired multi-
billion-dol lar taxpayer-fu nded bailouts. People did
not know if their bank would be arou nd tomorrow.
National authorities of crisis-hit economies star ted
to use stress tests e xtensively to reduce uncertainty
over bank health and decide what to do about v ul-
nerable bank s.
Stress tes ts ty pically c over solvency —whether
banks have enough capital to absorb losses—a nd
liquidity, whether they have enough cash to pay
out their deposits and other debts. Let’s say a bank
loses $1 billion when house prices drop by 50 per-
cent. e bank can sur vive—rema in solvent—if
its capital is $10 billion but not if it is $1 billion.
What if a bank ’s depositors panic and suddenly
withdraw $50 million? If the ban k is unable to
borrow money to replace those deposits, it can
survive if it owns as sets, such as government bonds,
that it can sell quick ly.
Severe but plausible
A key stress testi ng ingredient is an adverse scenario
that is severe yet plausible. A severe scenario sup-
poses a low-probability event that nevertheless ha s
potentially catast rophic consequences. Examples
include a once-in-a-century ear thquake, a repeat
of the 2008 nancia l crisis, or a government debt
default. Plausible scenarios exclude absurd hypo-
theticals, such a s a Martian invasion. Historical

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