What is 'Stress Testing'

Stress testing is a simulation technique often used in the banking industry. It is also used on asset and liability portfolios to determine their reactions to different financial situations. Additionally, stress tests are used to gauge how certain stressors will affect a company, industry or specific portfolio. Stress tests are usually computer-generated simulation models that test hypothetical scenarios; however, highly customized stress testing methodology is also often utilized.

BREAKING DOWN 'Stress Testing'

Stress testing is a useful method for determining how a portfolio will fare during a period of financial crisis. Stress testing is most commonly used by financial professionals for regulatory reporting and also for portfolio risk management.

Regulatory Stress Testing

Following the 2008 financial crisis, regulatory reporting for the financial industry and specifically banks was significantly expanded with a broader focus 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 for the banking industry. CCAR documentation requires banks to report on their internal procedures for managing capital and banks are required to include various stress-tested scenarios.

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

Currently, BASEL III is also in effect for global banks. This is a global reporting stress test that requires reporting documentation on banks’ capital levels with specified requirements for stress testing of various crisis scenarios.

Stress Testing for Risk Management

In investment portfolio management, stress testing is also commonly used for determining portfolio risk and setting hedging strategies to mitigate losses. Portfolio managers use internal proprietary stress testing programs to manage and test their portfolios against market occurrences and potential events.

Asset and liability matching stress tests are also widely used in business and investment management. Asset and liability matching stress tests can be used by companies to ensure proper internal controls and procedures. Retirement and insurance portfolios also greatly utilize stress testing to ensure efficient streams of cash flow and payout levels.

Types of Stress Testing

The use of Monte Carlo simulation is one of the most widely known methods of stress testing. This type of stress testing can be used for modeling probabilities of various outcomes given specific variables. Factors considered in the Monte Carlo simulation 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 for portfolio stress testing.

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