Stress testing has been a much-favored simulation technique used by banks to evaluate risk of having insufficient capital during tough times. Large financial institutes have been using stress tests as a form of scenario analysis ever since the early 1990s. They have become increasingly popular however, after the worldwide financial crisis that took place between 2007 and 2009, and has proven to be a fruitful endeavor when it comes to preventing undercapitalization in financial institutes.

Stress Testing Methodology

Focusing on critical risks like credit risk, market risk and liquidity risk, stress tests analyze the ability of a financial institution to withstand crisis situations in hypothetical scenarios. These scenarios are simulated using complex computer software and the subject of evaluation is always the bank’s balance sheet. The test is used to study the sensitivity of a bank when it is put through harsh economic changes. The stresses applied can be scaled from light to severe to produce dynamic results and to see how the bank performs under varying conditions. There are numerous factors that go into a stress test as you can see below:

Types of Stress Tests

Stress tests were typically performed by financial institutions themselves as a form of self-evaluation but beginning in 2007, regulatory bodies decided that it was necessary to conduct their own stress tests in order to ensure that banks can operate effectively.

Bank Stress Tests: These are bank-run tests that are conducted frequently (usually semi-annually). They go through strict reporting deadlines. The first report needs to be delivered to the Federal Reserve by the 5^th of January while the second needs to be delivered by the 5^th of July.
Federal Reserve Stress Tests: The Federal Reserve itself is required to run annual stress tests on financial institutions that have $50 billion or more in current assets. This test is referred to as the Dodd-Frank ActStress Test as it was a result of the passing of the bill of the same name in 2010.

Benefits of Stress Testing in Banks

Post Stress Capital – Since the initial adoption of the Dodd-Frank Act Stress Test the Federal Reserve has discovered that post-stress capital has generally increased. Due to results like this, the reserve is looking to simulate more complex scenarios in the near future.
Public Awareness – Banks that undergo stress testing are required to release the results of the tests to the general public. This means that customers can research and be cautious of how their bank would perform under major crises.
Bank Preparation – Using stress tests, banks can spot their weakness and amend them. If an actual economic disaster does arrive, the bank can then be prepared to face it.
Preventing Further Difficulties – Thanks to new regulations, financial institutions that fail the stress tests will have to cut their share buybacks and dividend payouts. This will allow the bank to preserve capital and prevent further financial challenges.

Stress Test Results 2017

2017 has been a great year for banks, in fact maybe the greatest. According to CNBC (https://www.cnbc.com/2017/06/22/big-banks-make-it-through-stress-tests-investors-await-cash-release.html), all 34 banks that were stress-tested passed and are permitted to pay-out shareholder dividends and buy back stock. This is the first time this has happened in the past 7 years, and it is truly a great victory for America’s top financial institutions. The results mean that even if we were to face a severe depression, America’s banks would be able to retain enough currency to be well-capitalized. CNN mentioned (http://money.cnn.com/2017/06/28/news/economy/fed-stress-test-wall-street-results/index.html) that the criteria used to create the hypothetical situation was:

An unemployment rate of 10%
Housing prices declining rapidly
Severe recession in eurozone

Every financial institute that was tested under these circumstances faced losses but the losses were not significant enough for them to ever be too concerned about them. These banks can continue to lend money to customers and businesses.

The biggest winners of 2017 include CIT Group, Goldman Sachs and Regions Financial reporting very high payout ratios (over 100 percent). If you would like the see the entire publication of the results you can find it at on the Federal Reserve’s official website (https://www.federalreserve.gov/publications/files/2017-dfast-methodology-results-20170622.pdf).

Future of Stress Testing

Stress testing as a form of scenario analysis is not going anywhere any time soon. It has proven to be an extremely successful technique and will no doubt continue to do so indefinitely. The 2007-2009 recession brought the most significant changes to stress testing since the Great Depression and I think there are more changes to come. The trump administration is looking to cut down banking regulations and make them more forgiving. On one hand, this means that banks will have to be less worried about passing the stress tests. On the other hand, this also means that they might be unprepared to deal with harsh economic conditions.