What Is Stress Testing?

Stress testing is a computer simulation technique used to test the resilience of institutions and investment portfolios against possible future financial situations. Such testing is customarily used by the financial industry to help gauge investment risk and the adequacy of assets and help evaluate internal processes and controls. In recent years, regulators have also required financial institutions to carry out stress tests to ensure their capital holdings and other assets are adequate.

Key Takeaways

  • Stress testing is a computer-simulated technique to analyze how banks and investment portfolios fare in drastic economic scenarios.
  • Stress testing helps gauge investment risk and the adequacy of assets, as well as to help evaluate internal processes and controls.
  • Stress tests can use historical, hypothetical, or simulated scenarios.
  • Regulations require banks to carry out various stress-test scenarios and report on their internal procedures for managing capital and risk.
  • The Federal Reserve requires banks with $100 billion in assets or more to perform a stress test.

Understanding Stress Testing

Companies that manage assets and investments commonly use stress testing to determine portfolio risk, then set in place any hedging strategies necessary to mitigate against possible losses. Specifically, their portfolio managers use internal proprietary stress-testing programs to evaluate how well the assets they manage might weather certain market occurrences and external events.

Asset and liability matching stress tests are widely used, too, by companies that want to ensure they have the proper internal controls and procedures in place. Retirement and insurance portfolios are also frequently stress-tested to ensure that cash flow, payout levels, and other measures are well aligned.

Regulatory Stress Testing

Following the 2008 financial crisis, regulatory reporting for the financial industry—specifically for banks—was significantly expanded, focusing on stress testing and capital adequacy, mainly due to the 2010 Dodd-Frank Act.

Beginning in 2011, new regulations in the United States required the submission of Comprehensive Capital Analysis and Review (CCAR) documentation by the banking industry. These regulations require banks to report on their internal procedures for managing capital and carry out various stress-test scenarios.

In addition to CCAR reporting, banks in the United States deemed too big to fail by the Financial Stability Board—typically those with more than $50 billion in assets—must provide stress-test reporting on planning for a bankruptcy scenario. In the government’s most recent reporting review of these banks in 2018, 22 international banks and eight based in the United States were designated as too-big-to-fail.

Currently, BASEL III is also in effect for global banks. Much like the U.S. requirements, this international regulation requires documentation of banks’ capital levels and the administration of stress tests for various crisis scenarios.

Stress testing involves running computer simulations to identify hidden vulnerabilities in institutions and investment portfolios to evaluate how well they might weather adverse events and market conditions.

Types of Stress Testing

Stress testing involves running simulations to identify hidden vulnerabilities. The literature about business strategy and corporate governance identifies several approaches to these exercises. Among the most popular are stylized scenarios, hypotheticals, and historical scenarios.

Historical Stress Testing

In a historical scenario, the business—or asset class, portfolio, or individual investment—is run through a simulation based on a previous crisis. Examples of historical crises include the stock market crash of October 1987, the Asian crisis of 1997, and the tech bubble that burst in 1999-2000.

Hypothetical Stress Testing

A hypothetical stress test is generally more specific, often focusing on how a particular company might weather a particular crisis. For example, a firm in California might stress-test against a hypothetical earthquake or an oil company might do so against the outbreak of war in the Middle East.

Stylized scenarios are a little more scientific in the sense that only one or a few test variables are adjusted at once. For example, the stress test might involve the Dow Jones index losing 10% of its value in a week.

Simulated Stress Testing

As for the methodology for stress tests, Monte Carlo simulation is one of the most widely known. This type of stress testing can be used for modeling probabilities of various outcomes given specific variables. Factors considered in the Monte Carlo simulation, for example, often include various economic variables.

Companies can also turn to professionally managed risk management and software providers for various types of stress tests. Moody’s Analytics is one example of an outsourced stress-testing program that can be used to evaluate risk in asset portfolios.

Advantages and Disadvantages of Stress Testing

Stress tests are forward-looking analytical tools that help financial institutions and banks better understand their financial position and risks. They help managers identify what measures to take if certain events arise and what they should do to mitigate risks. As a result, they are better able to form action plans to thwart threats and prevent failure. For investment managers, they are better able to assess how well managed assets might perform during economic downturns.

To perform stress tests, financial institutions need to create the framework and processes for which the tests can be performed. This restructuring is complex and is often associated with costly mistakes. For example, it's possible that the test scenario does not represent the types of risks a bank may face. This may be due to insufficient data or the test designer's inability to create a relevant test. In the end, the results of the test may lead to the creation of plans for events not likely to occur. This misrepresentation can cause institutions to ignore the risks that are possible.

Lastly, banks with unfavorable results may be barred from paying dividends to their customers and shareholders, as well as may be penalized.

Pros
  • Helps mitigate risks

  • Enables better financial planning

  • Highlights banks' or assets' strengths and weaknesses

Cons
  • May produce unfavorable consequences

  • Is complex and costly to administer

  • May result in inadequate planning

Example of Stress Testing

Banks and financial institutions often use the Federal Reserve's Dodd-Franklin Act Stress Test (DFAST) and Comprehensive Capital Analysis and Review (CCAR) stress test.

The Federal Reserve administers the Comprehensive Capital Analysis and Review stress test annually for banks with at least $100 billion in assets. This test identifies whether banks have sufficient capital to operate during economic downturns and plans in place to address such events and other associated risks. Specifically, the Federal Reserve looks at the bank's capital, its plans for its capital (e.g., dividends), and how it assesses capital needs.

The Dodd-Franklin Act Stress Test (DFAST), required for banks with at least $250 billion in assets, is often used in conjunction with the CCAR. This test can be conducted directly by the Federal Reserve or by financial institutions under the direction of the Fed. This, like the CCAR, reviews whether a bank or financial institution has enough capital to account for losses and continue operations in the event of economic turmoil.

As of March 2020, Federal Home Loan Banks are no longer required to conduct Dodd-Frank Act stress tests.

Although both tests have similar goals, they are administered differently to address as many possible events and risks.

Stress Testing FAQs

What Is Stress Testing?

Stress testing is an analytical technique to show how a financial services company or bank will be affected by certain financial events or situations. In other words, it shows what can happen and how well prepared institutions are when certain stressors are introduced.

What Is Stress Testing With an Example?

The Federal Reserve requires banks of a certain size to perform stress tests, such as the Dodd-Frank Act Stress Test (DFAST) or the Comprehensive Capital Analysis and Review (CCAR). These tests review the bank's capital and how well it can meet obligations and operate during trying economic times.

How Is Stress Testing Performed?

Stress testing is often performed using computer simulations, running different scenarios. Companies might use historical events, hypothetical situations, or simulations to test how well a company would operate under specific conditions.

What Happens if You Fail a Stress Test?

If a company fails a stress test, it may be required to increase its capital reserves or form contingency plans to address threats. In the banking and financial services industry, some failures result in fines or the prohibition of certain activities, such as paying dividends.

 The Bottom Line

Stress tests can be effective analytical tools in identifying whether a company has sufficient capital, strong assets, and effective plans to weather an economic storm. Companies can use historical, hypothetical, or simulated events to create test scenarios, or they may be required by a regulatory body to perform certain tests. The results can help companies better understand their strengths, weaknesses, and areas of opportunity.