Stress Testing

A stress test starts with a severe scenario, for example unemployment doubling, property prices falling by a third or a key counterparty failing. The firm then projects its losses, income, capital and liquidity under that scenario. Supervisors run or require such tests regularly for banks and insurers and publish pass or fail results in some countries. Firms also run their own, tied to capital planning. Reverse stress testing works the other way round: it starts from a failure, such as the firm running out of capital, and asks what events could cause it. Tests are not forecasts, and their value lies in what management does with the findings, such as raising capital or cutting concentrations. Management gets an early look at weaknesses that calm conditions and past data conceal, in time to raise capital or cut concentrations.

A regulator asks a bank to test a scenario in which GDP falls sharply and house prices drop by 30%. The bank projects higher defaults and finds its capital ratio would fall below the minimum in the second year. It responds by retaining profits and trimming high-risk mortgage lending.