What Bank Stress Testing Can and Can't Do

Leaders are taking a closer look at bank stress testing in the wake of bank failures in recent years. The significant impact of these collapses on the financial system, along with the government's extensive measures to prevent additional adverse scenarios , is increasing the sense of urgency around enhanced supervision by regulatory authorities.

In the Federal Reserve's latest financial stability report, the bank failures…were a new top concern for financial market participants, garnering mentions from 56% of respondents. —American Banker 

Banking stress tests are one way banks determine their own financial health and potential losses. They help bank leaders understand if they have sufficient capital available to make it through adverse conditions, like severe recessions or other types of financial market shock. Some tests are required by regulatory authorities and others are up to individual banks to complete. 

While bank stress tests provide valuable insight into the health of banks and their ability to withstand adverse economic conditions and market risks, it's important for leaders at financial institutions to understand the limitations of bank stress test exercises.

[ To learn about more holistic and integrated risk management in banking, view the webinar: Making the Case for Integrated Risk Management. ]

Stress tests help uncover vulnerabilities in a bank's balance sheet, capital adequacy, and risk management practices. By subjecting banks to specific hypothetical scenarios, this testing can reveal potential weaknesses that may appear during a time of financial crisis or economic shock.

Banks do some types of stress tests for strategic planning and others in accordance with requirements from the Federal Reserve to see how investment portfolios would react to various stress scenarios. Appian VP of industry solutions Michael Heffner recently told Information Week that when risks surface, banks have the opportunity to examine and reshape lending standards and how they operate:

“You're changing behavior and decisions around everything from lending standards to operational processes around how you control risk, which is a big deal for banks and capital market firms,” Heffner said.

Stress testing results provide valuable information for developing risk management strategies to respond to various economic conditions. Individual banks can use these insights to identify areas of improvement, adjust risk appetite, and enhance risk mitigation measures, as they do for risks related to managing the customer lifecycle.

In many jurisdictions, stress testing is a regulatory requirement intended to help economies avoid a banking crisis. By conducting stress tests in accordance with regulatory guidelines such as the US Federal Reserve Comprehensive Capital Analysis and Review (CCAR), Dodd-Frank Act Stress Tests (DFAST), the Bank of England Prudential Regulation Authority (PRA), the European Banking Authority (EBA), Hong Kong Monetary Authority (HMA), Bank of Canada's MacroFinancial Risk Assessment Framework (MFRAF), and others banks can ensure compliance and demonstrate their commitment to prudent risk management practices.

Stress testing is based on assumed common scenarios and models, which inherently involve uncertainties. While stress tests simulate potential adverse scenarios , they cannot predict the timing, severity, or nature of a future economic crisis, natural disaster, or other market shocks.

Stress test scenarios  are designed to capture known risks based on historical scenarios and data. However, they may not adequately account for emerging risks or unprecedented economic scenarios . As was the case with more recent bank failures, stress tests didn't anticipate elevated interest rates  and therefore failed to highlight the banks' weaknesses to this specific financial crisis.

While stress testing plausible scenarios can help identify vulnerabilities, performing them shouldn't be the only source for risk mitigation in banking. A bank can effectively pass some stress scenarios  and still face a banking crisis or collapse. Therefore, stress tests should be regarded as one piece of a larger risk management strategy.

Stress testing isn't the end-all be-all for risk management in banking, but from a regulatory standpoint it is certainly here to stay. Banks must effectively and efficiently execute these tests under tight time constraints while managing complex test procedures and gathering data from multiple disparate sources.

Financial institutions must implement solutions that can help enable more agile and effective stress test management and reporting to regulatory authorities. A unified platform for process automation that streamlines bank stress testing helps with all four of these key steps:

Improving access to necessary data provides banks with a solid foundation for conducting accurate, comprehensive, and effective stress tests. Look for a solution with data integration capabilities to connect disparate data sources and accelerate data gathering. A solution with a data fabric capability can also help spot check information while sampling and validating the transactional and analytics data store to better prepare for tests.

By streamlining workflows, stress test management can become more efficient, accurate, and collaborative. It saves time, reduces errors, enhances data management, promotes transparency, and enables scalability. Look for a solution that can design and automate the unique sequence of tasks and approvals required in the testing process, ensuring that each step is performed accurately and efficiently. With a centralized platform for test management, test cases can be created, executed, and tracked in one place, ensuring that all tests are conducted and recorded consistently and efficiently.

Improved process monitoring allows for real-time visibility into stress test activities. This in turn helps to improve quality assurance and facilitate up-to-date reporting, supporting continuous improvement, and meeting compliance standards. Look for a solution that enables real-time monitoring of the testing process, allowing financial companies to identify and address issues quickly. This monitoring should include both application and infrastructure performance monitoring, ensuring that performance issues are detected and resolved before they have an adverse impact on end users.

Better collaboration capabilities can support the efficiency and accuracy of test activities and improve reporting. Implement a solution with collaboration and reporting tools that enable teams to work together efficiently, share test results with stakeholders for additional analysis, and identify any areas that need further attention.

[ Get up to speed on integrated risk management in banking. Watch the webinar: Making the Case for Integrated Risk Management. ]