Fortifying Financial Foundations: A Guide to Stress Testing Scenarios for Banks

Even in the middle of a severe recession, the largest banks must have sufficient capital to lend money to businesses and individuals. But how do financial institutions verify they can withstand adverse scenarios and market shocks?

The Dodd-Frank Act, which Congress passed following the 2007-08 financial crisis, introduced capital stress testing requirements for all financial institutions with more than $50 billion in assets (this was later changed to include only banks with over $250 billion). Each year, the Office of the Comptroller of the Currency releases stress test scenarios for banks, and covered institutions must submit the results of their tests by April 5.

These tests shine a bright light on the stability of your institution, revealing whether you have the capital reserves required and the appropriate risk management strategies in place.

In this post, we’ll discuss what stress test scenarios are, the benefits, challenges, and how to simplify the process.

Bank stress tests are computer simulations focused on hypothetical scenarios, like a decline in house prices, economic downturn, tech bubble collapse, or other financial crisis. To future-proof your bank and maintain compliance, the tests typically examine one or more of several risk areas:

• Market

• Credit

• Liquidity

Stress test scenarios for institutions in the US use criteria published by the Federal Reserve to evaluate a financial institution’s ability to weather adverse market conditions and meet capital requirements. This includes a range of risks from a baseline scenario, where things remain relatively constant, to a severe global recession.

In the EU, the European Banking Authority (EBA) conducts EU-wide tests, as well as tests for individual banks.

Multiple variables and financial market conditions impact the results of the tests, including:

• Gross domestic product

• Interest rates

• Unemployment

• Exchange rates

• Commodities

• Equity

• Market rates

• Real estate prices

• Corporate debt markets

Stress test scenarios may use one or more of the variables above to evaluate the impact on a bank. Bank stress test exercises include hypothetical stresses like these:

• What happens if there's a 2 percentage point increase in interest rates?

• What happens if there's a 15 percentage point increase in unemployment?

• What happens if the stock market crashes?

• What happens if there’s a catastrophic hurricane?

These tests run through different economic scenarios to assess risks and potential losses a financial institution may face. The bank’s ability to withstand these hypothetical risks in the market entirely depends on the bank’s capital levels and financial health. They need to prove they have the capital adequacy ratio required by their governing regulatory body to cushion against losses. 

In short, stress tests give financial institutions the data to predict solvency and address resilience. If historical scenarios teach us anything, it’s that no entity is too big to fail.

For all their usefulness, stress tests aren’t exactly easy to execute. For one thing, they require a lot of data, and that data may not be readily accessible or well-organized. Validating, collecting, and aggregating data also requires a high level of complexity.

Added to the complexity of the process itself, your financial institution needs to keep up with regulations as they change and abide by regulatory reporting standards.

Finally, there are the resource demands of stress testing exercises. You need skilled personnel to set up and run the tests, plus the appropriate infrastructure. Depending on the size of your bank, dedicating an entire team to the administration of stress tests may or may not be feasible.

A simplified stress test management process is possible with the right tools and planning.

1. Define your goals, including the scope, reason for, and intended outcome of the test.

2. Collect the relevant data. Automation tools and data integration platforms streamline the process while ensuring you have the information required for the test.

3. Use technology, such as a process automation platform with artificial intelligence capabilities, to develop models that encompass the three risk areas and project the performance of the associated assets or liabilities.

Communicate the results of the tests, highlighting the relevant findings, risks, and potential adverse impact on your institution’s capital to regulators, board members, and all other stakeholders.

Regulatory demands continue to increase, with no end in sight. These additional requirements make traditional, manual stress test management more difficult.

Instead, consider using automation tools, such as data fabric, to enhance the efficiency and accuracy of your stress tests, by automating collection, consolidation and analysis of data. Removing manual processes minimizes errors while lowering costs.

And a platform for automation can help you adapt as regulations change, adjusting to new financial market scenarios and bank capital requirements.