Stress testing is a tool that measures the resilience of a financial institution or an entire financial system under different adverse events or scenarios. It is a quantitative – “what if” exercise, estimating what would happen to capital, profit and cash flows of individual financial institutions or the system as a whole if certain risks were to materialise.
Originally, stress testing as a tool was not developed in the area of finance, but in technical sciences. In the broadest sense, stress testing is a technique that measures the stability of an entity or a system under different unfavourable circumstances. In finance, stress test was initially used to assess features of individual portfolios or to measure stability of individual institutions (micro-stress tests). Later on, the methodology was used for testing the stability of groups of financial institutions which individually, or as a system, can affect the entire economy (macro-stress tests).
A complete stress testing exercise is more than just a numerical calculation of the impact of possible shocks. It involves choices of financial institutions, defining risks and scenarios, modelling solvency and liquidity shocks, preparing a strategy for the communication of the results, and, if necessary, developing follow-up measures to introduce (cancel) or intensify (moderate) macroprudental intervention. Stress tests typically evaluate two aspects of financial institutions’ performance: solvency and liquidity. Most stress tests focus on the banking sector, which is reasonable due to its vast impact on the real economy. However, new stress testing products are emerging, such as stability assessment of the nonbank sector, notably insurance and financial market infrastructure.
Solvency stress testing
An institution is solvent when the value of its assets is larger than its debt, i.e., when the value of equity capital is “positive”. The value of both assets and liabilities depends on future cash-flows, which are uncertain and depend on economic and financial conditions going forward. For an institution to be solvent, it would need to maintain a minimum of positive equity capital so that it can absorb potential losses in the event of a shock. Insolvency occurs when the amount of liabilities exceeds the level of assets, i.e. when the losses exceed the equity capital.
A solvency test assesses whether a financial institution or a system as a whole has sufficient capital to remain solvent in a hypothetically challenging environment by estimating profit buffers, losses and valuation changes.
In general, a financial institution’s solvency depends on the size of the equity capital, the level of expected cash-flows and their collection, maturity match in its balance sheet, credit concentration, and investments in sectors where unexpected events might cause losses.
The main risk factors are potential losses from borrowers’ default (credit risk), and losses from securities due to changes in market prices such as interest rates, exchange rates and equity prices (market risk).
A stress test may examine the impact of one source of risks (single factor tests, sensitivity stress test) or multiple sources of risks (multiple factor tests). Risk factors could be combined in an ad hoc manner (combined shock test) or generated more coherently using a macroeconomic framework (macro scenario tests).
A test for credit risk may cover total loans or loans to certain segments, such as retail lending, corporate lending, etc.
Estimating solvency ratios in macro scenario stress tests requires the existence of macroeconometric models. A macroeconometric model explains the dependency between key risk parameters (non-performing loan ratio, probability of default, loss given default, credit rating, etc.) and relevant macroeconomic variables, such as GDP, unemployment, exchange rate, and interest rate, etc. In addition, profit needs to be projected depending on the macroeconomic variables and the bank’s business model. Finally, it is necessary to make assumptions about financial institution’s behaviour (such as dividend payout policies and deleveraging, in case of adverse shocks), which increases the complexity of tests. Macro scenario stress tests usually cover several years (from one to three years), as credit risks materialise gradually.
Solvency can be measured based on the variation in the capital adequacy ratio, whose minimum values are set in the national legislation. Standard solvency indicators for financial institutions are the capital adequacy ratios (bank’s regulatory capital to risk-weighted assets), leverage ratios (capital to assets), losses in percent of capital, or capital shortfalls. Individual institutions or the system as a whole are said to “pass" or “fail” the test if the capital adequacy ratio is above a pre-determined threshold which is often set at the current minimum regulatory requirement. In addition, the central bank may set higher capital adequacy ratio if the control of creditworthiness and legality of operations shows that such higher ratio level is needed for the purpose of ensuring stable and secure operations of the bank, i.e. the bank’s fulfilment of obligations toward creditors.
Liquidity stress testing
Liquidity stress tests examine whether a bank can withstand a liquidity shock. Financial institutions may encounter sudden cash outflows, for instance, as a result of liquidity shortage, which has happened during the latest crisis. Financial intermediaries, particularly banks, might, as a result of the maturity mismatch in their balance sheet, face a problem of sudden withdrawal of deposits. If a large amount of deposits is withdrawn or interbank markets freeze, a bank faces liquidity shortage even if it is otherwise solvent.
If a bank has enough liquid assets, it can generate sufficient cash by selling the assets without making large losses. However, if its assets are mostly non-marketable loans or if the market value of collateral assets declines substantially below the book value (haircut), the bank will be short of liquidity. This is when liquidity affects the bank’s profitability, especially if the bank is not able to swiftly sell its assets without making losses, and is forced to ensure additional sources of funding at current market prices.
Liquidity and solvency stress events are often closely related and hard to separate. In the event of funding distress, a liquidity shortage may turn into a solvency problem if assets cannot be sold or can be sold only at loss-making prices (fire sales). Funding cost increase in a liquidity stress event is a factor that could affect the financial institution’s solvency.