Introduction to Stress Testing: Approaches, Methods and Applications

Banks across the globe faced significant challenges during the 2007–9 financial crisis. Declining capital ratios, equity prices, government takeovers and subsidies by the public sector have been norms rather than special cases in many healthy “free-market” economies. The crisis caused the confidence of investors, market makers and lenders to plummet. Local and international regulators attempted to restore confidence across the banking system in general, but particularly with the goal of boosting lending and capital structure. Among other initiatives, regulators are trying to implement stress testing of banks in order to lower or even prevent the possibility of a future banking crisis. The exact details of these tests vary according to specific economies and regulators, but all are intended to examine how banks perform under an adverse or unexpected economic environment, with regard to both macroeconomic uncertainty or bank-specific asset-liability and off-balance-sheet activities. These tests are designed not only to understand the vulnerability of banks, but also to make sure that banks are prepared to face adverse situations with the capital to mitigate potential losses or non