Stress test (financial)

In finance, a stress test is an analysis or simulation designed to determine the ability of a given financial instrument or financial institution to deal with an economic crisis. Instead of doing financial projection on a "best estimate" basis, a company or its regulators may do stress testing where they look at how robust a financial instrument is in certain crashes, a form of scenario analysis. They may test the instrument under, for example, the following stresses:

• What happens if unemployment rate rises to v% in a specific year?
• What happens if equity markets crash by more than w% this year?
• What happens if GDP falls by x% in a given year?
• What happens if interest rates go up by at least y%?
• What if half the instruments in the portfolio terminate their contracts in the fifth year?
• What happens if oil prices rise by z%?
• What happens if there is a polar vortex event in a particular region?

This type of analysis has become increasingly widespread, and has been taken up by various governmental bodies (such as the PRA in the UK or inter-governmental bodies such as the European Banking Authority (EBA) and the International Monetary Fund) as a regulatory requirement on certain financial institutions to ensure adequate capital allocation levels to cover potential losses incurred during extreme, but plausible, events. The EBA's regulatory stress tests have been referred to as "a walk in the park" by Saxo Bank's Chief Economist.^[1] This emphasis on adequate, risk adjusted determination of capital has been further enhanced by modifications to banking regulations such as Basel II. Stress testing models typically allow not only the testing of individual stressors, but also combinations of different events. There is also usually the ability to test the current exposure to a known historical scenario (such as the Russian debt default in 1998 or 9/11 attacks) to ensure the liquidity of the institution. In 2014, 25 banks failed in a stress test conducted by EBA.