What is a Bank Stress Test?

A bank stress test is an analysis conducted using weak and unfavorable economic situations to predict how banks are likely to perform when economic conditions are unfavorable. Basically, a bank stress test evaluates how well a bank would cope during economic crisis. This stress test is hypothetical and it uses unpalatable economic conditions such as Financial crisis, deep recession and others. This stress test seeks to examine the ability of banks to withstand economic downturn and hardships.

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How Does a Bank Stress Test Work?

The bank stress test uses hypothetical crises to examine how well banks would withstand these trying periods. The unfavorable economic scenarios used for the bank stress test are determined using factors from the International Monetary Fund (IMF) and the Federal Reserve. The stress test focuses on predicting the financial wellness of banks during economic crisis. This test focuses on;

• Market Risk,
• Credit risk, and
• Liquidity risk.

Bank stress tests become popular after the 2008 financial crisis which had an untold effect on banks and the economy at large. As a result of the financial crisis, many banks were heavily undercapitalized and unable to stand strong amidst the crisis. To prevent the occurrence of such, many banks adopted the use of bank stress tests. There are two types of stress tests;

1. Supervisory stress tests
2. Company-run stress tests.

The Federal Reserve conducts the first type of test annually, this is to ensure that banks have $50 billion or more in assets to enable them cope during financial crisis. The other type of test is done by banks. It is a form of internal stress tests conducted by the risk management team of banks. Predominantly, stress tests use similar financial scenarios such as deep recession and financial crisis to examine the ability of a bank to withstand the adverse effects of the financial crisis. For banks in Europe, the European Central Bank (ECB) has done requirements for back stress tests, they are called the strict stress testing requirements.

Impact of Stress Tests

Bank Stress tests help banks to determine whether they have enough capital to cope with the effect of financial crisis or not. Banks that undergo stress tests are required to publish their results which are thereafter shown to the public. If a bank fails the stress test, there is a regulation that mandates that such back cut the amount it pays as dividends and reduce share buybacks so that it can accumulate capital enough to withstand unfavorable economic scenarios. Banks that do not completely fail the stress test are given a conditional pass which requires them to up their game and accumulate more capital. These backs submit an action plan to the supervisory body to enable them follow up on the bank.