• Breana Patel , Risk &Regulatory Advisory at Bonova Advisory


• 18.10.2017 10:00 am
undisclosed

Stress testing has been a much-favored simulation technique used by banks to evaluate the risk of having insufficient capital during tough times. Large financial institutes have been using stress tests as a form of scenario analysis ever since the early 1990s. They have become increasingly popular, however, after the worldwide financial crisis that took place between 2007 and 2009, and has proven to be a fruitful endeavor when it comes to preventing undercapitalization in financial institutes. 

Stress Testing Methodology

Focusing on critical risks like credit risk, market risk, and liquidity risk, stress tests analyze the ability of a financial institution to withstand crisis situations in hypothetical scenarios. These scenarios are simulated using sophisticated computer software, and the subject of evaluation is always the bank's balance sheet. The test is used to study the sensitivity of a bank in the times of harsh economic conditions. The stresses applied can be scaled from light to severe to produce dynamic results and to see how the bank performs under varying conditions. Various factors considered into a stress test are as below:

• ¬    Model Design
• ¬    Coverage
• ¬    Capital
• ¬    Risk types
• ¬    Infrastructure

Types of Stress Tests

Financial Institutes performed stress tests internally as a form of self-evaluation but starting 2007; regulatory bodies decided that it was necessary to provide an oversight of the stress tests to ensure the safety and soundness of banks.  

• Bank Stress Tests: These are bank-run tests that are conducted frequently (usually semi-annually). They go through strict reporting deadlines. The first report needs to be delivered to the Federal Reserve by the 5^th of January while the second needs to be delivered by the 5^th of July.
• Federal Reserve Stress Tests: The Federal Reserve itself is required to run annual stress tests on financial institutions that have $50 billion or more in current assets. This test is referred to as the Dodd-Frank Act Stress Test as it was a result of the passing of the bill of the same name in 2010.

Benefits of Stress Testing in Banks

1. Post Stress Capital – Since the initial adoption of the Dodd-Frank Act Stress Test, the Federal Reserve has discovered that post-stress capital has increased. Due to such results, the reserve is looking to simulate more complex scenarios soon. 
2. Public Awareness – Banks that undergo stress testing are required to release the results of the tests to the general public. This means that customers can research and be cautious of how their bank would perform under major crises.
3. Bank Preparation – Using stress tests, banks can spot their weakness and amend them. If an actual economic disaster does arrive, the bank can then be prepared to face it.
4. Preventing Further Difficulties – Thanks to new regulations, financial institutions that fail the stress tests will have to cut their share buybacks and dividend payouts. It will allow the bank to preserve capital and prevent further economic challenges.

Stress Test Results 2017

2017 has been an excellent year for banks, in fact maybe the greatest. According to CNBC, all 34 banks that were stress-tested passed and are permitted to pay-out shareholder dividends and buy back stock. It is the first time this has happened in the past seven years, and it is indeed a great victory for America's top financial institutions. The results mean that even if we were to face a severe depression, America's banks would be able to  

retain enough currency to be well-capitalized. CNN mentioned that the criteria used to create the hypothetical situation was:

1. An unemployment rate of 10%
2. Housing prices declining rapidly
3. Severe recession in eurozone

Every financial institution that was tested under these circumstances faced losses, but the losses were not significant enough for them to ever be too concerned about them. These banks can continue to lend money to customers and businesses. Here's a concise report on the results of the annual stress test of 2017: 

The most prominent winners of 2017 include CIT Group, Goldman Sachs and Regions Financial reporting very high payout ratios (over 100 percent).

Future of Stress Testing

Stress testing as a form of scenario analysis is not going anywhere anytime soon. It has proven to be a hugely successful technique and will no doubt continue to do so indefinitely. The 2007-2009 recession brought the most significant changes to stress testing since the Great Depression, and I think there are more changes to come. The Trump administration is looking to cut down banking regulations and make them more forgiving. On the one hand, this means that banks will have to be less worried about passing the stress tests. On the other hand, this also means that they might be unprepared to deal with harsh economic conditions.