Main types of stress tests

Based on their ultimate objective

Macroprudential/surveillance stress testing

The primary objective of macroprudential stress tests is to assess the resilience and vulnerability of the entire financial system and the impact of the macroeconomic variables on the system stability as a whole, as well as on the individual financial institutions. This type of stress testing may also have other specific objectives, depending on the relevant context. One of such objectives is to identify weaknesses in the functioning of the financial system under normal circumstances so that they could be removed. Over the past two decades, many central banks have started using macroprudential stress tests to analyse system-wide risk, in addition to supervisory stress tests. Results of macroprudential stress tests are published in the Financial Stability Reports, as well as on the central banks’ websites. Since 1999, when FSAP was introduced , the International Monetary Fund regularly conducts macroprudential stress testing as part of its assessment of financial systems.

Macroprudential stress tests serve as a basis for macroprudential recommendations and usually do not propose bank-specific measures. Aggregated results of macroprudential stress testing, not stating the results for separate institutions, are reported in central banks’ Financial Stability Reports or FSSA reports prepared by the IMF. In the EU, the authorities publish the results of stress tests at group-level. Many central banks also publish test results for individual financial institutions.

Microprudential/supervisory stress testing

Microprudential/supervisory stress testing is usually used for assessing the resilience of individual institutions, i.e. the impact of specific risks on the institution’s stability.

Supervisory stress tests serve as a basis for targeted supervisory action and include a number of activities, ranging from a collection of more detailed data, assessment of capital adequacy for risks taken and designing specific measures such as recapitalisation, reduction of certain exposures, capping of dividends, and updating institution’s resolution plans.

Crisis management stress testing 

Even though macroprudential stress tests can be used as a basis for crisis management, this specific goal has led to the development of a new, specific category of stress tests. Stress testing has been fairly recently introduced as a tool for crisis management.

During the latest financial crisis, stress tests have been used as a tool for estimating bank recapitalisation needs of key financial institutions. For example, US banks were required to recapitalise based on the results of stress tests performed in 2009, and today, US regulators use stress tests when approving banks’ capital management plans (dividend payouts, bonus payments, recapitalisation needs…). Similarly, EU banks were required to recapitalise based on the results of stress tests conducted in 2010 and 2011 and organised by EBA. Detailed methodology and individual banks’ results were published.

In several recent examples of banking sector crisis (Ireland, Greece and Portugal), stress tests were used to estimate the recapitalisation needs.

Stress testing as an internal risk management tool

Financial institutions use stress testing to measure and manage risks. For example, J.P. Morgan uses value-at-risk (VaR) to measure market risk.

Stress tests typology according to the method used

Top-down approach

Top-down stress tests rely on reports of individual banks, the unique methodology and assumptions. In order for these stress tests results to be reliable, there must be a close cooperation between macroprudential and supervisory stress testers, as well as between banks and the central bank (supervisory authority).

Bottom-up approach

Bottom-up stress tests are not only conducted by individual financial institutions relying on internal data and modelling bank-specific risks, but are also used by the microprudential body.

According to the type of input reports

Стрес-тестови се ослањају на две врсте улазних података. Једну врсту чине биланси појединачних институција, док друга врста обухвата податке који се односе на финансијска тржишта, као што су, на пример, цене финансијских инструмената (акције, обвезнице или деривати). Како оба извора података имају предности и слабости, најбоље је користити и једне и друге.

Balance-sheet based stress tests

Balance-sheet based stress tests rely on the financial institutions’ regulatory reporting, such as balance sheets, income statements, cash flow statements, exposure reports, NPL reports, and other regulatory reports as secondary sources of information. These reports are submitted to central banks (supervisory authorities) in regular intervals (quarterly, monthly, daily). Balance-sheet based stress tests are more informative, which is an advantage, but are difficult to update given the large scope of historical data, which is a disadvantage of this type of tests. They are usually used by central banks, in the financial stability and supervision units.

Market price-based stress tests

This type of stress test is based on the financial market data. These tests are easy to update, since the input data are available on a daily basis. They are designed based on a portfolio analysis approach, and are mostly used to assess solvency and interdependence of key financial institutions.

These two methodologies do not convey the same type of information and they should be considered complementary rather than substitutes.

A common challenge for both types of models is finding a way to stress test individual institutions to system-wide risks. In the context of the balance sheet-based models, this can be done through network modelling, i.e. by keeping track of default effects of one institution on other institutions, or the system as a whole. Market price-based models, on the other hand, typically treat the banking system as a portfolio of banks and derive a distribution of systemic losses using portfolio analysis techniques similar to those used for individual bank portfolios.