Laws & Regulations

Bank stress test

What is a bank stress test?

A bank stress test is a hypothetical analysis to determine whether a bank has enough capital to withstand a negative economic shock. These include adverse situations such as a deep recession or a financial market crash. In the U.S., banks with $50 billion or more in assets are required to undergo internal stress tests conducted by their risk management teams and the Federal Reserve.

Bank stress tests were widely implemented after the 2008 financial crisis. Many banks and financial institutions are severely underfunded. The crisis exposed their vulnerability to market crashes and recessions. As a result, federal and financial authorities have greatly expanded regulatory reporting requirements, focusing on the adequacy of capital reserves and internal strategies for managing capital. Banks must regularly determine their solvency and record them.

key takeaways

  • A bank stress test is an analysis to determine whether a bank has enough capital to withstand an economic or financial crisis.
  • Bank stress tests were widely implemented after the 2008 financial crisis.
  • Federal and international financial authorities require all banks of a certain size to conduct stress tests and report the results regularly.
  • Banks that fail the stress test must take steps to preserve or increase their capital reserves.

How Bank Stress Tests Work

The stress tests focus on several key areas, such as credit risk, market risk and liquidity risk, to measure the financial health of banks in a crisis. Using computer simulations, what-if scenarios are created using a variety of Federal Reserve and International Monetary Fund (IMF) standards. The European Central Bank (ECB) also has stringent stress testing requirements covering around 70% of banking institutions across the euro area. The stress tests run by the company are conducted semi-annually and within tight reporting deadlines.

All stress tests include a standard set of scenarios that a bank may encounter. A hypothetical situation might involve a specific disaster in a specific location—a hurricane in the Caribbean or a war in North Africa. Or it could include all of the following at the same time: a 10% unemployment rate, a 15% general decline in stocks, and a 30% house price crash. Banks may then use projected financials over the next nine quarters to determine whether they have enough capital to weather the crisis.

Historical scenarios also exist based on real financial events in the past. The bursting of the tech bubble in 2000, the subprime mortgage crisis in 2007, and the coronavirus crisis in 2020 are just the most prominent examples. Others include the stock market crash of 1987, the Asian financial crisis of the late 1990s, and the European sovereign debt crisis of 2010-2012.

In 2011, the United States created regulations requiring banks to conduct a comprehensive capital analysis and review (CCAR), which includes running various stress test scenarios.

Benefits of Bank Stress Testing

The main goal of a stress test is to see if a bank has the funds to manage itself during difficult times. Banks subjected to stress tests must publish their results. Those results are then released to the public to show how the bank would respond to a major economic crisis or financial catastrophe.

Regulations require companies that fail the stress test to cut dividend payments and share buybacks to preserve or build up their capital reserves. This prevents undercapitalized banks from defaulting and stops a bank run before it begins.

Sometimes, banks pass stress tests conditionally. This means the bank is on the verge of failure and risks being unable to make distributions in the future. Reducing the dividend in this way usually has a strong negative impact on the stock price. Thus, the conditional pass encourages banks to build up reserves before being forced to cut dividends. In addition, conditionally approved banks must submit action plans.

Criticisms of Bank Stress Tests

Critics claim that stress tests are often too demanding. By requiring banks to withstand once-in-a-century financial disruptions, regulators are forcing them to retain excess capital. As a result, the supply of credit to the private sector is insufficient. This means creditworthy small businesses and first-time homebuyers may not be able to get loans. The relatively slow pace of economic recovery after 2008 has even been blamed for overly strict capital requirements for banks.

Critics also claim the bank’s stress tests lack sufficient transparency. Some banks may keep more capital than necessary in case requirements change. The timing of stress tests is sometimes unpredictable, making banks wary of extending credit during normal fluctuations in business. On the other hand, disclosing too much information could allow banks to artificially increase reserves in time for testing.

Real examples of bank stress tests

Many banks fail stress tests in the real world. Even prestigious institutions can fall. For example, Santander and Deutsche Bank have repeatedly failed stress tests.

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