Stress Testing Lessons from the Banking Turmoil of 2023

Abstract

Despite the clear success of stress testing as a crisis and peacetime risk management and
capital adequacy tool, the series of bank failures and resultant turmoil in the banking system
revealed flaws in the stress testing regime that today governs the regulatory capital regime.
We make four recommendations for improving stress testing, and specifically suggest: 1)
using multiple scenarios to allow exploration of a wider set of risks; 2) disclosing (stressed)
fair value for the assessment of all securities held on banks’ balance sheets; 3) stress testing of
funding and liquidity risk; and 4) subjecting more banks to the stress tests. Taken together,
these reforms would usefully improve the dynamism of the financial regulatory regime.

Keywords: financial regulation, stress-testing, financial stability, crisis, bank capital

JEL Classification: G28, E58, G21