Stress Testing Definition - Investopedia

Stress testing is a computer-driven simulation technique for evaluating banks and asset portfolios on how they might react in various situations. FundamentalAnalysis Tools TableofContents Expand TableofContents WhatIsStressTesting? UnderstandingStressTesting RegulatoryStressTesting TypesofStressTesting ProsandConsofStressTesting ExampleofStressTesting StressTestingFAQs TheBottomLine WhatIsStressTesting? Stresstestingisacomputersimulationtechniqueusedtotesttheresilienceofinstitutionsandinvestmentportfoliosagainstpossiblefuturefinancialsituations.Suchtestingiscustomarilyusedbythefinancialindustrytohelpgaugeinvestmentriskandtheadequacyofassetsandhelpevaluateinternalprocessesandcontrols.Inrecentyears,regulatorshavealsorequiredfinancialinstitutionstocarryoutstressteststoensuretheircapitalholdingsandotherassetsareadequate. KeyTakeaways Stresstestingisacomputer-simulatedtechniquetoanalyzehowbanksandinvestmentportfoliosfareindrasticeconomicscenarios.Stresstestinghelpsgaugeinvestmentriskandtheadequacyofassets,aswellastohelpevaluateinternalprocessesandcontrols.Stresstestscanusehistorical,hypothetical,orsimulatedscenarios.Regulationsrequirebankstocarryoutvariousstress-testscenariosandreportontheirinternalproceduresformanagingcapitalandrisk.TheFederalReserverequiresbankswith$100billioninassetsormoretoperformastresstest. UnderstandingStressTesting Companiesthatmanageassetsandinvestmentscommonlyusestresstestingtodetermineportfoliorisk,thensetinplaceanyhedgingstrategiesnecessarytomitigateagainstpossiblelosses.Specifically,theirportfoliomanagersuseinternalproprietarystress-testingprogramstoevaluatehowwelltheassetstheymanagemightweathercertainmarketoccurrencesandexternalevents. Assetandliabilitymatchingstresstestsarewidelyused,too,bycompaniesthatwanttoensuretheyhavetheproperinternalcontrolsandproceduresinplace.Retirementandinsuranceportfoliosarealsofrequentlystress-testedtoensurethatcashflow,payoutlevels,andothermeasuresarewellaligned. RegulatoryStressTesting Followingthe2008financialcrisis,regulatoryreportingforthefinancialindustry—specificallyforbanks—wassignificantlyexpanded,focusingonstresstestingandcapitaladequacy,mainlyduetothe2010Dodd-FrankAct. Beginningin2011,newregulationsintheUnitedStatesrequiredthesubmissionofComprehensiveCapitalAnalysisandReview(CCAR)documentationbythebankingindustry.Theseregulationsrequirebankstoreportontheirinternalproceduresformanagingcapitalandcarryoutvariousstress-testscenarios. InadditiontoCCARreporting,banksintheUnitedStatesdeemedtoobigtofailbytheFinancialStabilityBoard—typicallythosewithmorethan$50billioninassets—mustprovidestress-testreportingonplanningforabankruptcyscenario.Inthegovernment’smostrecentreportingreviewofthesebanksin2018,22internationalbanksandeightbasedintheUnitedStatesweredesignatedastoo-big-to-fail. Currently,BASELIIIisalsoineffectforglobalbanks.MuchliketheU.S.requirements,thisinternationalregulationrequiresdocumentationofbanks’capitallevelsandtheadministrationofstresstestsforvariouscrisisscenarios. Stresstestinginvolvesrunningcomputersimulationstoidentifyhiddenvulnerabilitiesininstitutionsandinvestmentportfoliostoevaluatehowwelltheymightweatheradverseeventsandmarketconditions. TypesofStressTesting Stresstestinginvolvesrunningsimulationstoidentifyhiddenvulnerabilities.Theliteratureaboutbusinessstrategyand corporategovernance identifiesseveralapproachestotheseexercises.Amongthemostpopulararestylizedscenarios,hypotheticals,andhistoricalscenarios. HistoricalStressTesting Inahistoricalscenario,thebusiness—orassetclass,portfolio,orindividualinvestment—isrunthroughasimulationbasedonapreviouscrisis.Examplesofhistoricalcrisesincludethe stockmarket crashofOctober1987,the Asiancrisisof1997,andthe techbubble thatburstin1999-2000. HypotheticalStressTesting Ahypotheticalstresstestisgenerallymorespecific,oftenfocusingonhowaparticularcompanymightweatheraparticularcrisis.Forexample,afirminCaliforniamightstress-testagainstahypotheticalearthquakeoranoilcompanymightdosoagainsttheoutbreakofwarintheMiddleEast. Stylizedscenariosarealittlemorescientificinthesensethatonlyoneorafewtestvariablesareadjustedatonce.Forexample,thestresstestmightinvolvethe DowJones indexlosing10%ofitsvalueinaweek. SimulatedStressTesting Asforthemethodologyforstresstests,MonteCarlosimulationisoneofthemostwidelyknown.Thistypeofstresstestingcanbeusedformodelingprobabilitiesofvariousoutcomesgivenspecificvariables.FactorsconsideredintheMonteCarlosimulation,forexample,oftenincludevariouseconomicvariables. Companiescanalsoturntoprofessionallymanagedriskmanagementandsoftwareprovidersforvarioustypesofstresstests.Moody’sAnalyticsisoneexampleofanoutsourcedstress-testingprogramthatcanbeusedtoevaluateriskinassetportfolios. AdvantagesandDisadvantagesofStressTesting Stresstestsareforward-lookinganalyticaltoolsthathelpfinancialinstitutionsandbanksbetterunderstandtheirfinancialpositionandrisks.Theyhelpmanagersidentifywhatmeasurestotakeifcertaineventsariseandwhattheyshoulddotomitigaterisks.Asaresult,theyarebetterabletoformactionplanstothwartthreatsandpreventfailure.Forinvestmentmanagers,theyarebetterabletoassesshowwellmanagedassetsmightperformduringeconomicdownturns. Toperformstresstests,financialinstitutionsneedtocreatetheframeworkandprocessesforwhichthetestscanbeperformed.Thisrestructuringiscomplexandisoftenassociatedwithcostlymistakes.Forexample,it'spossiblethatthetestscenariodoesnotrepresentthetypesofrisksabankmayface.Thismaybeduetoinsufficientdataorthetestdesigner'sinabilitytocreatearelevanttest.Intheend,theresultsofthetestmayleadtothecreationofplansforeventsnotlikelytooccur.Thismisrepresentationcancauseinstitutionstoignoretherisksthatarepossible. Lastly,bankswithunfavorableresultsmaybebarredfrompayingdividendstotheircustomersandshareholders,aswellasmaybepenalized. Pros Helpsmitigaterisks Enablesbetterfinancialplanning Highlightsbanks'orassets'strengthsandweaknesses Cons Mayproduceunfavorableconsequences Iscomplexandcostlytoadminister Mayresultininadequateplanning ExampleofStressTesting BanksandfinancialinstitutionsoftenusetheFederalReserve'sDodd-FranklinActStressTest(DFAST)andComprehensiveCapitalAnalysisandReview(CCAR)stresstest. TheFederalReserveadministerstheComprehensiveCapitalAnalysisandReviewstresstestannuallyforbankswithatleast$100billioninassets.Thistestidentifieswhetherbankshavesufficientcapitaltooperateduringeconomicdownturnsandplansinplacetoaddresssucheventsandotherassociatedrisks.Specifically,theFederalReservelooksatthebank'scapital,itsplansforitscapital(e.g.,dividends),andhowitassessescapitalneeds. TheDodd-FranklinActStressTest(DFAST),requiredforbankswithatleast$250billioninassets,isoftenusedinconjunctionwiththeCCAR.ThistestcanbeconducteddirectlybytheFederalReserveorbyfinancialinstitutionsunderthedirectionoftheFed.This,liketheCCAR,reviewswhetherabankorfinancialinstitutionhasenoughcapitaltoaccountforlossesandcontinueoperationsintheeventofeconomicturmoil. AsofMarch2020,FederalHomeLoanBanksarenolongerrequiredtoconductDodd-FrankActstresstests. Althoughbothtestshavesimilargoals,theyareadministereddifferentlytoaddressasmanypossibleeventsandrisks. StressTestingFAQs WhatIsStressTesting? Stresstestingisananalyticaltechniquetoshowhowafinancialservicescompanyorbankwillbeaffectedbycertainfinancialeventsorsituations.Inotherwords,itshowswhatcanhappenandhowwellpreparedinstitutionsarewhencertainstressorsareintroduced. WhatIsStressTestingWithanExample? TheFederalReserverequiresbanksofacertainsizetoperformstresstests,suchastheDodd-FrankActStressTest(DFAST)ortheComprehensiveCapitalAnalysisandReview(CCAR).Thesetestsreviewthebank'scapitalandhowwellitcanmeetobligationsandoperateduringtryingeconomictimes. HowIsStressTestingPerformed? Stresstestingisoftenperformedusingcomputersimulations,runningdifferentscenarios.Companiesmightusehistoricalevents,hypotheticalsituations,orsimulationstotesthowwellacompanywouldoperateunderspecificconditions. WhatHappensifYouFailaStressTest? Ifacompanyfailsastresstest,itmayberequiredtoincreaseitscapitalreservesorformcontingencyplanstoaddressthreats.Inthebankingandfinancialservicesindustry,somefailuresresultinfinesortheprohibitionofcertainactivities,suchaspayingdividends.  TheBottomLine Stresstestscanbeeffectiveanalyticaltoolsinidentifyingwhetheracompanyhassufficientcapital,strongassets,andeffectiveplanstoweatheraneconomicstorm.Companiescanusehistorical,hypothetical,orsimulatedeventstocreatetestscenarios,ortheymayberequiredbyaregulatorybodytoperformcertaintests.Theresultscanhelpcompaniesbetterunderstandtheirstrengths,weaknesses,andareasofopportunity. ArticleSources Investopediarequireswriterstouseprimarysourcestosupporttheirwork.Theseincludewhitepapers,governmentdata,originalreporting,andinterviewswithindustryexperts.Wealsoreferenceoriginalresearchfromotherreputablepublisherswhereappropriate.Youcanlearnmoreaboutthestandardswefollowinproducingaccurate,unbiasedcontentinour editorialpolicy. Moody'sAnalytics."ChallengesandPitfallsofStressTesting."AccessedJune15,2021. TheFederalReserve."StressTestsandCapitalPlanning."AccessedJune15,2021. FederalHousingFinanceAgency."Dodd-FrankActStressTests(DFAST)."AccessedJune15,2021. CompareAccounts AdvertiserDisclosure × TheoffersthatappearinthistablearefrompartnershipsfromwhichInvestopediareceivescompensation.Thiscompensationmayimpacthowandwherelistingsappear.Investopediadoesnotincludealloffersavailableinthemarketplace. Provider Name Description RelatedTerms BankStressTest Abankstresstestisananalysistodeterminewhetherabankhasenoughcapitaltowithstandanegativeeconomicshock. more UnderstandingScenarioAnalysis Scenarioanalysisistheprocessofestimatingtheexpectedvalueofaportfolioafteragivenchangeinthevaluesofkeyfactorstakeplace. more SupervisoryCapitalAssessmentProgram(SCAP) TheSupervisoryCapitalAssessmentProgram(SCAP)wasastresstestofAmerica'slargestbanks,conductedbytheFederalReserveduringthe2008–2009financialcrisis. more SystemicallyImportantFinancialInstitution(SIFI)Definition Asystemicallyimportantfinancialinstitution(SIFI)isafirmthatregulatorsfeelwouldposeaseriousrisktotheeconomyifitweretocollapse. more Contingency Acontingencyisapotentialnegativeeventthatmayoccurinthefuture,suchasanaturaldisaster,fraudulentactivityoraterroristattack. more Dodd-FrankWallStreetReformandConsumerProtectionAct TheDodd-FrankWallStreetReformandConsumerProtectionActisaseriesoffederalregulationspassedtopreventfuturefinancialcrises. more PartnerLinks RelatedArticles Laws&Regulations WhatMajorLawsWereCreatedAfterthe2008FinancialCrisis? Macroeconomics WhatisStressTestinginValueatRisk(VaR)? Banking APrimeronImportantU.S.BankingLaws CFA WhatToExpectontheCFALevelIExam RiskManagement WhatAretheBiggestRisksofBanksToday? FederalReserve WhatistheFederalReserveBoard'smarketriskcapitalrule?