Bank Stress Test

What is a Bank Stress Test?

A bank stress test is an assessment performed to determine a bank’s financial health and ability to endure economic adversity. The stress test aims to offer investors with meaningful information, increase bank operations transparency, and boost consumer trust.

It is a reliable method for analysing the quality of the banking sector. The test result will help the organizations to protect themselves from failures by taking precautionary measures.

Key Takeaways
  • Bank stress test is an examination conducted primarily to scrutinize bank’s financial viability when exposed to difficult operational conditions in domestic and international markets.
  • In the United States, stress test conducted by Federal Reserve includes Dodd-Frank Act Stress Test (DFAST) and Comprehensive Capital Analysis & review (CCAR).
  • The general variables used in the stress test are GDP, interest rate, unemployment, exchange rates, real estate price, and stock prices.
  • Based on test result, regulatory agencies monitor and control bank’s credit supply, share buybacks, and other actions.

How Does Bank Stress Test Work?

Bank Stress Test

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Bank stress tests are progressive. Generally, banks pass or fail the test based on the capital level analyzed during the economic downturn. If they can maintain minimum required capital during financial adversities, they get a pass in the stress test; otherwise, they fail. Failure in the trial will force them to limit certain activities like dividend distribution and share repurchasesShare RepurchasesShare buyback refers to the repurchase of the company’s own outstanding shares from the open market using the accumulated funds of the company to decrease the outstanding shares in the company’s balance sheet. This is done either to increase the value of the existing shares or to prevent various shareholders from controlling the company.read more.

In the United States, the Federal Reserve accomplishes the stress test by completing two tests- the Dodd-Frank Act stress test (DFAST) and Comprehensive Capital Analysis & Review (CCAR). DFAST measures bank financial performance under hypothetical economic scenarios. CCAR analyses the proposed capital action plans for the upcoming four quarters prepared by the bank to measure the capacity of the bank to handle the impact of the economic downturn.

Common Bank Stress Scenario Variables

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The stress test examines how financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more will thrive when people may not pay back loans or interests. The common hypothetical economic scenarios include economic shocks like recession and soaring unemployment. The typical stress scenario variables used in the test are GDP, interest rate, unemployment, exchange rates, real estate price, and stock prices. In addition, the test majorly focuses on credit riskCredit RiskCredit risk is the probability of a loss owing to the borrower's failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt's principal and an interest component, resulting in interrupted cash flow and increased cost of collection.read more, market riskMarket RiskMarket risk is the risk that an investor faces due to the decrease in the market value of a financial product that affects the whole market and is not limited to a particular economic commodity. It is often called systematic risk.read more, and liquidity riskLiquidity RiskLiquidity risk refers to 'Cash Crunch' for a temporary or short-term period and such situations are generally detrimental to any business or profit-making organization. Consequently, the business house ends up with negative working capital in most of the cases.read more.

According to the Federal Reserve, for the year 2014, the catastrophic scenario for DFAST consists of a massive recession with an unemployment rate of 11.25%, a GDP fall above 4%, a 50% collapse in the stock marketStock MarketStock Market works on the basic principle of matching supply and demand through an auction process where investors are willing to pay a certain amount for an asset, and they are willing to sell off something they have at a specific price.read more, a 25% reduction in real estate values, and a roughly 35% drop in commercial real estate prices.

Bank Stress Test Example

Federal Reserve Stress Test 2021

The economic recessionEconomic RecessionEconomic recession is when economic activity is stagnant, and there is contraction in the business cycle, over-supply of goods compared to its demand, and a higher unemployment rate resulting in lower household savings and lower expense, inflation, higher interest rate and economic crisis due to higher fiscal deficit.read more of 2007-2009 mandated the stress test to large banks in the United States.  In the year 2021, the Federal Reserve released its annual bank stress test result 2021. A severe worldwide recession that affects commercial real estate and corporate loan holders, with 10.8% unemployment, results in a 55% loss in the stock market altogether forms the hypothetical economic scenario to run the test.

It is disclosed to the public that all 23 institutions maintained a minimum required capital levels during a hypothetical economic downturn even though they have a combined loss of $474 billion. Nevertheless, passing the test enabled them to resume and boost share buyback and dividend distribution to investors.

Advantages

  1. Transparency: Stress test discloses relevant information to investors and other consumers, mitigating future financial panic scenarios. Based on the stress test review, depositors can assess the institution’s health and deposit in a healthy one.
  2. Guidance for preventive measures from regulatory bodies: Financial institutions that failed in the test are obliged to follow the restrictions set by regulatory bodies like decreasing the new issue of risky credit, dividend distribution, share repurchase, and overall credit card risk exposureRisk ExposureRisk Exposure refers to predicting possible future loss incurred due to a particular business activity or event. You can calculate it by, Risk Exposure = Event Occurrence Probability x Potential Lossread more annually. This prevents the banks from facing further economic and financial adversities. It also helps the banks in preserving capital.
  3. Improved risk management: It will save banks from the adverse impact of stock market bubblesStock Market BubblesA stock market bubble is a phenomenon in which the prices of a company's stock are inflated and cannot be supported by the company's actual performance, resulting in a divide between the real and financial economies caused by irrational exuberance of market participants, herd mentality, or any other similar reason.read more. The test result shows banks their weakness and facilitates them to rectify the same and, in the process, avoid economic disaster.
  4. Situational policy updation: Banks can initiate alternate methods like lowering the interest rate, rewards to favor existing consumers in case of stall on credit facilities imposed by the government due to failure in the test.
  5. Systemic risk: Stress tests can reduce systemic riskSystemic RiskSystemic risk is the probability or unquantified risk of an event that could trigger the downfall of an entire industry or an economy. It happens when capital borrowers like banks, big companies, and other financial institutions lose capital provider's trust like depositors, investors, and capital markets.read more, for instance, the risk faced due to Covid 19 pandemic scenarios.

Limitations

  1. Affects credit supply & cash flow: Various studies point out that bank stress tests may negatively affect credit conditions or credit supply affecting average consumers. Moreover, a decrease in cash flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more affects the economic growth.
  2. The weak proportional relationship between result publication & stock returns: The equity marketEquity MarketAn equity market is a platform that enables the companies to issue their securities to the investors; it also facilitates the further exchange of these stocks between the buyers and sellers. It comprises various stock exchanges like New York Stock Exchange (NYSE).read more reacts to the stress test result depending on the economic scenario. For instance, a positive reaction to the result occurs when the economy is in crisis and vice versa.
  3. Lack of accurate solutions: The stress test result does not provide adequate or pinpoint solutions to deal with the adverse scenario.
  4. Variation of results: The simulation test result is not always in line with the actual case scenarios.
  5. Complexity: Stress testing may be challenging due to factors like cost and effort.

Frequently Ask Questions (FAQs)

What is a stress test for a bank?

The stress test assesses a bank’s elasticity in response to different economic situations. It estimates whether the bank has the financial strength to survive economic downturns healthily.

Who does stress testing at a bank?

In the United States, Federal Reserve System regulates the stress test. In Europe, the central regulatory bodies which govern the process are the Financial Services Authority (Stress and scenario testing CP08/24), Bank of England (Stress test Bank of England namely- Annual industry stress test), and European Banking Authority.

What is Dodd-Frank stress testing?

DFAST assesses the financial health of banks in the context of probable economic situations. For example, according to the Dodd-Frank Act Stress Test 2020, 33 Banks in the United States may suffer considerable losses if subjected to very unfavourable scenarios.

This has been a Guide to what is Bank Stress Test is and its Definition. Here we discuss how does bank stress test works along with an example, advantages, and limitations. You can learn more from the following articles –