Objectives and Challenges for Stress Testing

Forthcoming in J. Doyne Farmer, Alissa Kleinnijenhuis, Til Schuermann, Thom Wetzer (eds.), Handbook of Financial Stress Testing, Cambridge University Press

35 Pages Posted: 1 Jan 2020

See all articles by Richard J. Herring

Richard J. Herring

University of Pennsylvania - Finance Department

Til Schuermann

Oliver Wyman

Date Written: December 16, 2019

Abstract

Stress testing proved to be an effective crisis fighting tool in the Great Financial Crisis and has since become widely used by regulators and financial institutions to test resilience to financial and economic shocks. This served two objectives: (1) to identify and remediate banks with a capital shortfall, and (2) to restore confidence in the core of the banking system by requiring that banks eliminate any regulatory capital shortfall promptly either by raising capital in private markets or, if unable, from a government backstop fund. The objectives of a stress test will determine six fundamental choices in structuring the exercise: (1) the design of stress scenarios; (2) the risk exposures to be stressed; (3) the range of institutions to be tested, the length of the scenario and the intervals over which shocks are measured; (4) the development of models to map shocks into outcomes and impact on individual bank financials and on the banking system; (5) the choice of criteria to determine whether banks pass or fail the stress test; (6) the decision about what to disclose to the public. But stress tests are no panacea. We discuss a range of challenges to improving the effectiveness of stress tests, such as incorporating nonfinancial risks like cyber, taking into account second-round effects of shocks, broadening the scope beyond just banks, and resisting a tendency to disaster myopia as memories of the financial crisis recede into the past.

Keywords: risk measurement, risk management, capital adequacy, macroprudential policy

JEL Classification: G21, G28, G32

Suggested Citation

Herring, Richard J. and Schuermann, Til, Objectives and Challenges for Stress Testing (December 16, 2019). Forthcoming in J. Doyne Farmer, Alissa Kleinnijenhuis, Til Schuermann, Thom Wetzer (eds.), Handbook of Financial Stress Testing, Cambridge University Press , Available at SSRN: https://ssrn.com/abstract=3504347 or http://dx.doi.org/10.2139/ssrn.3504347

Richard J. Herring

University of Pennsylvania - Finance Department ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States
215-898-5613 (Phone)
215-898-2067 (Fax)

Til Schuermann (Contact Author)

Oliver Wyman ( email )

1166 6th Avenue
New York City, NY
United States

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