A Wider Field of Vision

• Author: Dimitri G. Demekas

A Wider Field of Vision Finance & Development, September 2015, Vol. 52, No. 3

Dimitri G. Demekas

Stress tests must be adapted and broadened to assess the stability of the financial system as a whole

When engineers want to make sure a structure or a system is well designed, they employ a technique called stress testing: they expose the system to shocks and strains that are far greater than what will be experienced in normal use to confirm specifications are met, determine breaking limits, or examine modes of failure.

Managers of financial institutions and, more recently, financial regulators adapted the tool of stress testing to measure the strength of individual financial institutions. They do so by subjecting portfolios to numerical simulations of large hypothetical “shocks,” such as a severe recession, housing price decline, or stock market crash, and estimating their effect on profits, capital, or the ability of financial institutions to continue meeting their obligations. But using stress tests to assess the resilience of the financial system as a whole is not as simple as adding up the results for the individual institutions. New approaches and techniques are needed to make stress tests a useful tool for financial stability analysis.

Simple startStress tests were first used for banks in the early 1990s (see box). These early models were relatively simple: they assumed an exogenous shock and traced the impact of associated losses on the capital of the individual bank. They made simplistic assumptions about how the bank would react to the shock—in terms of profit distribution, credit expansion, or debt reduction, for example. They focused on the solvency of the bank (how much capital it had left after the shock). The risk that an institution would run out of cash (liquidity risk) was treated independently from solvency, if at all, and interactions among banks and the feedback effects on the economy as a whole were generally ignored.

Origins of financial stress testingOne of the early adopters of stress tests was the U.S. financial services firm JPMorgan Chase & Co., which in the early 1990s used what is called value at risk (VaR) methodology to measure the market risk of a given shock—how much the changes in asset prices would affect the value of the bank’s portfolio.

Regulators soon caught up. It had long been understood that banks financing themselves with government-insured deposits have an incentive to take excessive risks. So the goal of capital regulation was to force banks to internalize at least some of the unexpected losses should these risks materialize, thus mitigating moral hazard and protecting depositors. Regulators saw that stress testing was a way to estimate potential losses under adverse scenarios, and could be a key input in capital regulation.

Stress tests became a regulatory staple in the early 2000s, when the international rules on capital adequacy known as Basel II required banks to perform stress tests for market risk and, in some cases, credit risk. These tests had to be “plausible, severe, and relevant” to help banks evaluate their capacity to absorb losses and identify steps they could take to reduce risk and conserve capital (BCBS, 2005). Equipped with this tool, regulators could ensure the soundness of each institution by requiring it to hold a minimum amount of capital in proportion to its risky assets.

These stress tests had what economists call a microprudential, or single-institution, focus: their objective was to assess the likelihood of failure of individual institutions under adverse conditions. This, in turn, it was thought, would ensure the stability of the financial system as a whole.

Too much and too littleBut even as bank regulators were adopting stress tests, many understood that ensuring the soundness of each institution was neither necessary nor sufficient to ensure that the financial system as a whole would remain stable and continue to function. As the late Andrew Crockett, then general manager of the Bank for International Settlements, put it, the microprudential approach to financial regulation may “strive for too much and deliver too little.”

It may strive for too much because the occasional failure of an individual institution is not a problem if other institutions can step in and serve its clients, borrowers, and depositors. Building a regulatory system designed to avoid any failures risks providing excessive protection.

And it may deliver too little because firm-level...