Stress Testing - Definition
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What is Stress Testing?
Stress testing refers to a computerized process of testing the ability of companies (primarily financial institutions) and investment portfolios to maintain a level of efficiency in unfavorable future financial or economic situations. Corporations carry out stress testing so as to know how strong they will be and how reliable their performance or investment portfolios will be during extreme financial conditions.
Regulatory Stress Testing
The 2010 Dodd-Frank Act strengthened the need for stress testing. This was after the 2008 financial crisis that affected the economy. One example is the Comprehensive Capital Analysis and Review (CCAR) by banks. This is to ensure that stress testing is done when necessary by banks and the develop strategies to manage their capital.
Globally, there is provision for an international regulation that ensures stress testing by institutions. The BASEL III has been effected and must be carried out by banks across the globally.
Types of Stress Testing
There are three major types of stress testing, that are;
- Stylized scenarios stress testing - In a Stylized scenario stress testing, scientific measures are deployed to check vulnerability in companies as well as ways to maintain efficiency during unfavorable situations.
- Hypothetical stress testing - In a hypothetical stress testing is based on testing on institutions with peculiar crisis manage them. This is more specific, it measures how a firm hedges a crisis.
- Historical scenario stress-testing - In a historical scenario stress testing, individual investments and assets are tested using a computer simulation technique based on historical crisis of past events of crisis. Historical crises such as Asian crisis of 1997, the tech bubble of 199-2000 and the 1987 stock market crash can be used. Aside from the three types of stress testing listed above, there are other stress test methodologies.