What Is a Bank Stress Test?

A bank stress test is an analysis conducted under hypothetical unfavorable economic scenarios, such as a deep recession or financial market crisis, designed to determine whether a bank has enough capital to withstand the impact of adverse economic developments. In the United States, banks with $50 billion or more in assets are required to undergo internal stress tests conducted by their own risk management teams as well as by the Federal Reserve.

Bank stress tests were widely put in place after the 2007-2009 global financial crisis, the worst in decades. The ensuing Great Recession left many banks and financial institutions severely undercapitalized or revealed their vulnerability to market crashes and economic downturns. As a result, federal and financial authorities greatly expanded regulatory reporting requirements to focus on the adequacy of capital reserves and internal strategies for managing capital. Banks must regularly determine their solvency and document it.

Key Takeaways

  • A bank stress test is an analysis to determine whether a bank has enough capital to withstand an economic or financial crisis, using a computer-simulated scenario.
  • Bank stress tests were widely put in place after the 2007-2009 global financial crisis.
  • Federal and international financial authorities require all banks of a certain size to regularly conduct stress tests and report the results.
  • Banks that fail their stress tests must take steps to preserve or build up their capital reserves.

How a Bank Stress Test Works

To determine banks' financial health in crisis situations, stress tests focus on a few key areas, such as credit risk, market risk, and liquidity risk. Using computer simulations, hypothetical crises are created using various criteria from the Federal Reserve and International Monetary Fund (IMF). The European Central Bank (ECB) also has strict stress testing requirements that cover approximately 70% of the banking institutions across the eurozone. Company-run stress tests are conducted on a semiannual basis and fall under strict reporting deadlines.

All stress tests include a common set of scenarios, some worse than others, for banks to experience. A hypothetical situation might involve a specific disaster in a specific place—a Caribbean hurricane or war in Northern Africa. Or it could involve all of the following happening at the same time: a 10% unemployment rate, a general 15% drop in stocks, and a 30% plunge in home prices.

Historical scenarios also exist, based on real crises in the past: the Great Depression, the 1999-2000 bursting of the tech bubble, the subprime mortgage meltdown of 2007.

Banks then use the next nine quarters of projected financials to determine if they have enough capital to make it through the crisis.

In 2011, the U.S. instituted regulations that required banks to do a Comprehensive Capital Analysis and Review (CCAR), which includes running various stress-test scenarios.

Impact of a Bank Stress Test

The main goal of a stress test is to see whether a bank has the capital to manage itself during tough times. Banks that undergo 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 economic crisis or a financial disaster.

Regulations require companies that do not pass stress tests to cut their dividend payouts and share buybacks to preserve or build up their capital reserves. Obviously, banks that fail stress tests look bad to the public. Even prestigious institutions can stumble: Santander and Deutsche Bank, for example, have failed stress tests multiple times.

Sometimes banks are given a conditional pass of a stress test. This means a bank came close to failing 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.