What is a bank stress test?
A bank stress test is a method for measuring and predicting the ability of a bank to respond to and withstand certain hypothetical—but plausible—negative economic events, such as a recession or pandemic.
During a financial crisis, overextended banks run the risk of becoming undercapitalized if they do not prudently manage risk and maintain adequate cash reserves. A failing bank of sufficient size can have a cascading effect on national and global financial systems, resulting in exponential damage—all of which underscores the critical importance for bank stress testing.
Bank stress tests are a subset of a larger methodology of stress testing used in finance to evaluate the resiliency of many types of financial instruments, such as stocks, bonds, and other types of financial institutions, like hedge funds. Since banks, especially large ones, are more likely to hold an outsized influence on broader financial systems, it is especially necessary to ensure that a bank is prepared to respond to various potential stresses.
While there are many ways to perform a bank stress test, generally, the process involves modeling projected profits, losses and risks to create a financial projection. Banks, like most businesses, already create these projections as a part of their normal risk management and vulnerability management operations and to inform short- and long-term decision-making.
However, for a stress test, analysts make special projections based on the hypothetical impact of certain possible adverse scenarios, such as:
- An increase in unemployment rates to X% in a given year
- A decline in equity markets greater than Y% in a given year
- A decline in GDP by Z% in a given year
- An increase in interest rates to A%, B% or C%, etc
- An unforeseen increase in closed contracts by Q%
- A sharp increase in the price of oil, gas or other energy resources
- An ‘act-of-god’, such as a blight impacting food production in a given region, a political conflict impeding global shipping lanes, or a global pandemic driving decreased spending
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Mandatory bank stress testing requirements were widely adopted by global regulatory bodies following the 2008 financial crisis, during which unprecedented levels of borrowers were forced to default on so-called sub-prime mortgage contracts. Significantly undercapitalized banks were unable to cover losses from devalued mortgages, resulting in a devastating impact beginning in the housing markets and extending throughout the financial services industry. The fallout included the following:
Triggering the Great Recession, the single worst economic downturn since the Great Depression, the severity of the 2008 crisis instigated the creation of new regulatory agencies, including the Troubled Assets Relief Program (TARP), the Financial Stability Oversight Council (FSOC), and the Consumer Financial Protection Bureau (CFPB).
In recent years, bank stress testing has grown increasingly common. Governing bodies like the United States Federal Reserve (the Fed), the United Kingdom’s Prudential Regulation Authority, the European Banking Authority (EBA) and the International Monetary Fund have all adopted mandatory bank stress testing as part of their broader regulatory requirements to ensure sufficient capital allocation levels necessary to cover any predictable losses resulting from extreme, but not implausible, events.
U.S. banks are required to undergo internal stress testing semiannually, with tight reporting deadlines. They are also required to submit to supervisory stress tests conducted by government authorized regulators. During the annual supervisory stress test cycle, the Federal Reserve creates and releases four documents to establish the official parameters and requirements of the year’s test and to share the results transparently with the public. The four documents can be found on the official Federal Reserve Dodd-Frank Stress Test Publications website and include the following:
- Stress test scenarios: Details describing the hypothetical economic conditions used in the supervisory stress test, typically published in mid-February.
- Stress test methodology: Details about the models and methods used in the supervisory stress test, typically published at the end of Q1.
- Supervisory stress test results: Reports the aggregate and individual bank results, typically published at the end of Q2.
- Large bank capital requirements: An official announcement of the capital reserves required for all large banks (USD 100B+ in assets). The capital requirement is informed by the results of the stress testing and is typically published during Q3.
All assessments must include a standardized set of stress test scenarios, such as a tsunami in Southeast Asia, a 5% dip in commercial real estate sales, a 30% drop in small business sales or a combination of multiple economic shocks at once. Historical examples based on real economic conditions of the past, such as the tech bubble collapse of 2000, the coronavirus pandemic in 2020 and the stock market crash in 1987, are also often used for simulating economic conditions and market volatility.
During a stress test, analysts make projections for their next nine quarters based on the actual bank balance sheets as well as the required hypothetical scenarios to determine if they have sufficient capital ratios to continue making distributions during a severe recession, either proving adequate capital reserves or exposing any vulnerabilities which may lead to a banking system collapse.
Supervisory bank stress testing overview
The Federal Reserve is tasked with carrying out supervisory stress tests and publishes detailed documents with regards to how the annual test cycle will be conducted, issuing guidelines and announcing any relevant updates when needed. The process follows a standardized procedure:
- The Federal Reserve develops stress test scenarios based on current and historical real-world analysis.
- The Federal Reserve creates, selects and adjusts stress test models to simulate hypothetical scenarios and provide standardized parameters for individual banks to apply selected models.
- Banks submit detailed bank data.
- The Federal Reserve inputs the scenario data and unique bank data into the stress test models to create projections of each bank’s expected performance under the previously selected hypothetical stress scenarios.
The Federal Reserve uses the results of the supervisory stress test, in part, to set capital requirements for participating banks, issues any necessary regulatory consequential orders, and publishes their findings. Financial institutions are required by law to comply with transparent supervisory stress testing. Firms whose stress-test results fail to demonstrate sufficient bank capital are required to cut dividend payouts and share buybacks to preserve or build up capital reserves. As these can often carry significant consequences for an individual bank’s stock prices, some banks that fail their annual stress test may avoid severe penalties by presenting a rigorous action plan to prove or improve the adequacy of their capital buffer.
Large, international banks have been using stress testing since the early 1990s to predict their ability to maintain basic operations even during times of significant economic hardship. In 1996, the Basel Committee on Banking Supervision, an international banking regulatory advisory, amended the Basel Capital Accord to require banks and investment firms to conduct stress testing. Although the committee’s recommendations are often implemented by various regional governments, they do not have the authority to specifically enforce accord requirements. Until 2007, banks—specifically in the United States—typically only performed stress testing on themselves at their own discretion.
Responding to the 2008 financial crisis, the U.S. federal government passed the Dodd-Frank Wall Street Reform and Consumer Protection Act with the goal of reforming the financial regulatory system and preventing “too big to fail” institutions from failing to adequately prepare for foreseeable market downturns.
As part of this reform, in 2011, the U.S. instituted further regulations requiring banks to submit to Comprehensive Capital Analysis and Review (CCAR), which includes various stress tests.
In October 2012, U.S. regulators expanded this practice to require large banks to undertake stress tests twice per year: once internally and once under the supervision of federal regulators. Dodd-Frank Act Stress Testing (DFAST) requirements were further extended in 2014 to include midsized firms holding assets in the USD 10-50 billion range.
Bank stress tests provide valuable information on the health of the world’s most important financial institutions and help ensure that banks meet critical capital requirements to prolong economic growth. Stress testing helps banks and regulators predict, prepare for, and mitigate potential economic crises and maintain a robust and resilient global financial system.
Since initiating Dodd-Frank stress testing, the Federal Reserve has found that post-stress capital has increased. Last year, a Fed press release announced that, according to annual stress testing, while large banks may endure a greater loss compared to previous years’ results, they are well positioned to survive foreseeable market challenges and retain minimum capital requirements.