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 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 do internal stress tests by their own risk management team as well as by 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 conducted on a semiannual basis and fall under strict reporting deadlines.

The European Central Bank (ECB) also has strict stress testing requirements that cover approximately 70 percent of the banking institutions across the eurozone.

All stress tests include a common set of scenarios, some worse than others, for banks to evaluate. An example is the hypothetical situation of all of the following happening at the same time: a 10 percent unemployment rate, a general 15 percent drop in stocks, and a 30 percent 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 pass 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 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. Supervisory Capital Assessment ...

    A financial stress test conducted by the Federal Reserve System ...
  2. Acceptance Testing

    Acceptance testing, in the engineering and software industries, ...
  3. Test

    A test is when a stock’s price approaches an established support ...
  4. Bank

    A bank is a financial institution licensed as a receiver of deposits. ...
  5. Runs Test

    A runs test is a statistical technique to test the hypothesis ...
  6. Gray Box

    Gray box is the testing of software with limited knowledge of ...
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. Investing

    Citi Attractive Ahead of Stress Test: Deutsche Bank

    Deutsche Bank analysts don't believe Citigroup's recent slide is likely to continue.
  3. Investing

    RBS Fails Central Bank Test (RBS, HSBC)

    RBS failed a key test from the Bank of England, while Santander, Barclays and HSBC faced close scrutiny.
  4. 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.
  5. Managing Wealth

    Jobs With Great Pay, But Huge Stress

    You may want these jobs for the pay and the benefits, but the work can be a killer.
  6. Investing

    Big Banks Hike Dividends After Fed's Stress Test

    JPMorgan and Citigroup are among the banks dishing out more to shareholders after proving their capital reserves can weather financial turmoil.
  7. Investing

    Berkshire To Be Largest Bank of America Shareholder

    Warren Buffett's Berkshire Hathaway will hold more than $17 billion worth of Bank of America stock.
  8. Personal Finance

    10 Stressful Jobs With Low Pay

    If you're doing one of these jobs, it's probably for reasons other than the pay, whether it's helping people, your country or your community.
  9. Investing

    Focusing on Big Banks Is a Mistake: Dick Bove

    The strategist reminds investors that the banking sector is made up of 400 companies.
  10. Investing

    Why Bank Stocks May Be Ready to Rebound

    The Federal Reserve is expected to approve big increases in bank dividends and stock buybacks this week.
RELATED FAQS
  1. 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 >>
  2. Do financial advisors get drug tested?

    Financial advisor regulatory bodies do not require drug testing but many individual firms that hire advisors do. Read Answer >>
  3. What is the average profit margin for a company in the banking sector?

    Learn what the average profit margin is for companies in the banking sector, along with other evaluation metrics often used ... Read Answer >>
  4. What is the banking sector?

    Learn why the banking sector is a vital industry to our economy, what it does to drive the economic growth and understand ... Read Answer >>
Trading Center