Stress Testing Banks: Whence and Whither?

Abstract

This paper provides a brief overview of the recent practice of stress testing banking institutions, focusing on capital adequacy. We argue that stress testing has been successfully used to mitigate bank opacity; quantify systemic risk under extreme but plausible stress; keep the participants mindful of severely adverse shocks, thereby mitigating “disaster myopia” and concomitant financial instability; and improve the data collection and analytical capabilities of financial institutions. Our paper then reviews several critiques of stress testing made by policymakers and academics. We also propose several modifications of the current stress testing practice, such as the fusion of liquidity and capital adequacy stress testing, expansion of granular data availability, and explicit modeling of sectors inextricably connected to banking as well as the feedback mechanisms from these sectors. Addressing these issues is likely to keep stress testing highly relevant for promoting financial stability in the future.