Objectives and Challenges for Stress Testing

Stress testing proved to be an effective crisis fighting tool in the Great Financial Crisis and has since become widely used by regulators and financial institutions to test resilience to financial and economic shocks. This served two objectives: (1) to identify and remediate banks with a capital shortfall, and (2) to restore confidence in the core of the banking system by requiring that banks eliminate any regulatory capital shortfall promptly either by raising capital in private markets or, if unable, from a government backstop fund. The objectives of a stress test will determine six fundamental choices in structuring the exercise: (1) the design of stress scenarios; (2) the risk exposures to be stressed; (3) the range of institutions to be tested, the length of the scenario and the intervals over which shocks are measured; (4) the development of models to map shocks into outcomes and impact on individual bank financials and on the banking system; (5) the choice of criteria to determine whether banks pass or fail the stress test; (6) the decision about what to disclose to the public. But stress tests are no panacea. We discuss a range of challenges to improving the effectiveness of stress tests, such as incorporating nonfinancial risks like cyber, taking into account second-round effects of shocks, broadening the scope beyond just banks, and resisting a tendency to disaster myopia as memories of the financial crisis recede into the past.