Stress Testing Banks

Abstract

How much capital and liquidity does a bank need – to support its risk taking activities? During the recent (and still ongoing) financial crisis, answers to this question using standard approaches, e.g. regulatory capital ratios, were no longer credible, and thus broad-based supervisory stress testing became the new tool. Bank balance sheets are notoriously opaque and are susceptible to asset substitution (easy swapping of high risk for low risk assets), so stress tests, tailored to the situation at hand, can provide clarity by openly disclosing details of the results and approaches taken, allowing trust to be regained. With that trust re-established, the cost-benefit of stress testing disclosures may tip away from bank-specific towards more aggregated information. This paper lays out a framework for the stress testing of banks: why is it useful and why has it become such a popular tool for the regulatory community in the course of the recent financial crisis; how is stress testing done – design and execution; and finally, with stress testing results in hand, how should one handle their disclosure, and should it be different in crisis vs. “normal” times.

Keywords: capital requirements, leverage, systemic risk

JEL Classification: G21, G28, G20