What is a 'Bank Stress Test'

A bank stress test is an analysis conducted under unfavorable economic scenarios designed to determine whether a bank has enough capital to withstand the impact of adverse developments. Banks with $50 billion in assets are required to do internal stress tests by their own risk management team and also stress tests from the Federal Reserve.

BREAKING DOWN 'Bank Stress Test'

Stress tests focus on a few key risks, such as credit risk, market risk and liquidity risk, to banks' financial health in crisis situations. Hypothetical crises are determined using various factors from the Federal Reserve and International Monetary Fund (IMF). Bank stress tests were put in place and became more widespread after the 2007-2009 global financial crisis, the worst since the Great Depression. This crisis left many banks and financial institutions severely undercapitalized, which the stress tests aim to prevent.

Two Types of Stress Tests

The Federal Reserve conducts annual supervisory stress tests of banks with $50 billion or more in assets. The main goal of this stress test is to see whether a bank has the capital to manage itself during tough times.

Company-run stress tests are done on a semi-annual basis and fall under strict reporting deadlines. The results of these company-run tests have to be reported to the Federal Reserve by Jan. 5 and July 5.

Both stress tests come with a common set of scenarios for banks to evaluate. An example is the hypothetical situation of a 10% unemployment rate, 5% drop in stocks and 30% plunge in home prices. Banks then use the next nine quarters of projected financials to determine if they have enough capital to make it through the crisis.

Impact of Stress Tests

Banks that go through stress tests are required to publish their results. These results are then released to the public to show how the bank would handle a major crisis. New regulations require companies that do not pass stress tests to cut their dividend payouts and share buybacks to preserve capital.

Sometimes banks are given a conditional basis passing of a stress test. This means a bank came close to failing the stress test and risks being able to make further distributions in the future. Banks that pass on a conditional basis have to resubmit a plan of action. Banks that fail the stress tests look bad to the public based on the threat of a financial disaster. Foreign banks such as Santander and Deutsche Bank have failed stress tests multiple times.

RELATED TERMS
  1. Stress Testing

    A simulation technique used on asset and liability portfolios ...
  2. Bank

    A financial institution licensed as a receiver of deposits. There ...
  3. Capital Requirement

    The standardized requirements in place for banks and other depository ...
  4. National Bank

    In the United States, a commercial bank chartered by the comptroller ...
  5. Test

    In technical analysis, it is when a stock price approaches a ...
  6. European Banking Authority (EBA)

    The European Banking Authority (EBA) is a regulatory body that ...
Related Articles
  1. Managing Wealth

    An Investor's Guide To Bank Stress-Testing

    Just how are bank stress tests performed and what is the logic behind them? And is a stress test useful for evaluating a bank's stock?
  2. Personal Finance

    U.S. Banks Pass First Part of Annual Fed Stress Test (JPM, C)

    The 33 U.S. banks tested to ensure they have enough capital to weather a severe economic downturn all passed.
  3. Investing

    Banking Stress Tests: Would Yours Pass?

    In weaker economic times, banks may be tested by the government to see how safe they are.
  4. Insights

    Fed's Tarullo Talks Amid Simmering Bank Revolt (MS)

    Big banks may be considering legal action against the Fed over new stress-test rules regarded as onerous by the industry
  5. Managing Wealth

    4 Ways Companies Can Relieve Workplace Stress

    Workplace stress can cost companies tons of money in lost productivity and absenteeism. Some of that is out of their control, but often they are the cause.
  6. Insights

    Who Has the Most Stressful Job?

    Government workers have the most stressful jobs, at least in Britain. Here's where job stress comes from.
  7. Investing

    Why Are Banks Hold Nearly $2.5 Trillion in Bonds?

    Banks are holding the biggest dollar amount of bonds since the central bank began compiling data in 1973
  8. Financial Advisor

    Why Asset Managers Oppose Mutual Fund Stress Tests

    The Financial Stability Board wants to implement a financial stress test for mutual funds for the G20 nations. Here's why it is an unpopular idea.
  9. Investing

    Hedge Fund Slump Hits Revenues At Deutsche Bank

    A slump in the hedge fund industry has affected revenues at Deutsche Bank AG's Prime Finance unit.
  10. Personal Finance

    8 Careers That Pay Less Than You Think

    If you ever thought EMTs or reporters make a lot of money, you'd be wrong.
RELATED FAQS
  1. How stressful is the typical corporate finance job?

    Learn more about careers in corporate finance, the stress associated with those jobs and why investment bankers feel the ... Read Answer >>
  2. What is stress testing in Value at Risk (VaR)?

    Discover the difference between Value at Risk, or VaR, and stress testing, and learn how the two concepts might be used together ... Read Answer >>
  3. What average annual growth rate is typical for the banking sector?

    Learn the typical average annual growth rate for the banking sector and why regulatory requirements have a profound effect ... Read Answer >>
  4. What factors are the primary drivers of banks' share prices?

    Find out which factors are most important when determining the share price of banks and other lending institutions in the ... Read Answer >>
  5. What economic indicators are important to consider when investing in the banking ...

    Find out which economic indicators are most useful for investors in the banking sector, especially those influenced by central ... Read Answer >>
  6. What do banks do to control the bank reserve?

    Understand what the Federal Reserve does in order to expand or contract the economy. Learn what depository institutions can ... Read Answer >>
Hot Definitions
  1. Leverage

    1. The use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment. ...
  2. Trumponomics

    Trumponomics is a term for the economic policies of President Donald Trump.
  3. Universal Health Care Coverage

    An organized healthcare system that provides healthcare benefits to all persons in a specified region. Many countries, such ...
  4. Davos World Economic Forum

    The annual meeting of the World Economic Forum hosted at Davos—a small ski town in Switzerland—in January each year is among ...
  5. Smart Home

    A convenient home setup where appliances and devices can be automatically controlled remotely from anywhere in the world ...
  6. Efficient Frontier

    A set of optimal portfolios that offers the highest expected return for a defined level of risk or the lowest risk for a ...
Trading Center