How do bank stress-tests work?

This would be a very high-level simplification of what in reality is an incredibly complex exercise involving risk modeling experts and quants.

Banking “stress tests” are usually presented to the bank by regulators as a macroeconomic scenario (i.e.: unemployment rate increases, inflation decreases, etc.) which must then be converted to financial “risk factors” that impact the bank in some way.

“Risk factors” are key factors that are likely to cause volatility (unexpected changes) in the value of some asset or asset group of the bank’s, impacting its value or performance. For instance, in an equity investment, the risk factor would be the volatility of the stock price. For loans, it might be the probability of default of a corporation.

In order to translate the impact of this macroeconomic scenario, banks sometimes use factor models. These models are often based on historical statistical relationships, although a degree of judgement is often exercised, and attempt to map the sensitivity of risk factors to macroeconomic variables.

Once the risk factors have been adjusted by the factor models, a separate group of models are then run with these new risk factor values as inputs, and the bank can then generate stressed financial statements (stressed balance sheet and stressed income statement) to assess the financial impact of the scenario.

By Bruce Haydon

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