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Bank Stress Test Definition
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.
A Little More on What is a Bank Stress Test
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;
- Supervisory stress tests
- 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.
Reference for “Bank Stress Test”
Academics research on “Bank Stress Test”
Information asymmetry in US banks and the 2009 bank stress test, Quijano, M. (2014). Information asymmetry in US banks and the 2009 bank stress test. Economics Letters, 123(2), 203-205. I examine if the 2009 bank stress test conducted by the Federal Reserve conveyed new information to investors. By analyzing bank bond returns, I show that the announcement of the bank stress test results mitigated information asymmetries in US banks.
Banking stress test effects on returns and risks, Neretina, E., Sahin, C., & De Haan, J. (2015). Banking stress test effects on returns and risks. We investigate the effects of the announcement and the disclosure of the clarification, methodology, and outcomes of the US banking stress tests on banks’ equity prices, credit risk, systematic risk, and systemic risk during the 2009-13 period. We find only weak evidence that stress tests after 2009 affected equity returns of large US banks. In contrast, CDS spreads declined in response to the disclosure of stress test results. We also find that bank systematic risk, as measured by betas, declined in some years after the publication of stress test results. Our evidence suggests that stress tests affect systemic risk.
Capital market consequences of EU bank stress tests, Ellahie, A. (2013). Capital market consequences of EU bank stress tests. Available at SSRN 2157715. This paper examines the capital market consequences of government stress testing of banks in the European Union during the recent global financial crisis. Theory suggests that the announcement of forthcoming public disclosure and the eventual disclosure can induce changes in the information environment. Compared with propensity score matched control firms, I report that the announcement of stress tests generally elicited weak effects from measures of information asymmetry and information uncertainty for tested banks. I also report that after disclosure of 2011 test results, information asymmetry declined gradually but information uncertainty increased significantly. This suggests that while the revealed information enabled sorting of strong and weak banks, uncertainty worsened either due to low test credibility and unresolved bank capital plans, or due to negative signals about fundamentals. Furthermore, I document evidence that the unprecedented level of sovereign and total Exposure At Default disclosure in the 2011 test results had directional information content for measures of information asymmetry, information uncertainty, CDS spreads and equity returns. Collectively, the evidence highlights the importance of transparent and credible stress tests supported by a strong regulatory commitment to remedy negative outcomes.
Anticipating uncertainty, reviving risk? On the stress testing of finance in crisis, Langley, P. (2013). Anticipating uncertainty, reviving risk? On the stress testing of finance in crisis. Economy and Society, 42(1), 51-73. Widely regarded as a watershed moment in the governance of the present global financial crisis, the US Treasury’s Supervisory Capital Assessment Program (SCAP) of spring 2009 undertook to ‘stress test’ the solvency of the largest American banks by projecting their capital adequacy going forward. The SCAP is shown to have been an important intervention that restored market confidence in US banks because it rigorously embraced and acted through a subtle but significant change in the repertoires of risk management, a very public turn to anticipatory techniques designed to ensure preparedness for low-probability, high-impact events. And, as the subsequent failures of stress-testing exercises to inspire confidence in European banking are also shown to demonstrate, the performative power of these anticipatory techniques itself turns on their seemingly precise methodological application and animation by a positive affective charge.
Stress testing of banks: an introduction, Dent, K., Westwood, B., & Segoviano Basurto, M. (2016). Stress testing of banks: an introduction. Bank of England Quarterly Bulletin, Q3. The usage and prominence of bank stress tests has risen substantially in the years following the global financial crisis. They are now established as a key part of the bank regulation toolkit. Typically, bank stress tests measure the resilience of banks to hypothetical adverse scenarios like severe recessions, with results used by central banks and regulators to measure risks and manage them through the setting of prudential policy. Over time, to enhance their usefulness to policymakers, stress tests are likely to develop further, for example by testing banks against a wider range of resilience metrics than capital, and further exploring how stresses might be transmitted across the financial system (e.g. through contagion).
Approach to commercial bank’s stress test on residential mortgage loan [J], LIU, P., & TIAN, C. Y. (2008). Approach to commercial bank’s stress test on residential mortgage loan [J]. Science-Technology and Management, 1. Based on both the demonstration of risk factors in real estate loan market and the comparison of various risk management methods,the paper educes the conclusion that using stress test as a way of real estate loan risk management is not only necessary but also feasible.Further more the structure and techniques of a stress test system are discussed in detail,where foreign theories and practice are used as reference.
The adoption of stress testing: Why the Basel capital measures were not enough, Wall, L. D. (2014). The adoption of stress testing: Why the Basel capital measures were not enough. Journal of Banking Regulation, 15(3-4), 266-276. The Basel capital adequacy ratios lost credibility with financial markets during the financial crisis. This article argues that the failure was because of the reliance of the Basel standards on overstated asset values in reported equity capital. The US stress tests were able to assist in restoring credibility, in part because they could capture deterioration in asset values. However, whether stress tests will prove equally valuable in the next crisis is not clear. Only some of the weaknesses in the Basel ratios are being addressed. Moreover, the US tests’ success was because of a combination of circumstances that may not exist next time.