Stress Testing: A Measure of Financial Stability across ASEAN-5

Abstract

A banking operation is at the epicenter of financial intermediation, and there is no perfect substitute for it in capital markets. Because a banking operation revolves around a constant inventory of risks, in the event of a financial or economic crisis, banks therefore get hit as the first line of defense, and then the broader economic activity is adversely affected if the financial turmoil exacerbates. Today, all central banks of ASEAN-5 design and conduct own micro and macro stress tests as a measure of financial stability. The main results of all three stress scenarios (i.e. baseline, adverse, and severely adverse) are not only informative to central banks and regulatory supervisors, but they contribute positively to the policy decision-making process; stress testing results also help bank executives (and risk managers) better manage risks, and academia for research. Stress testing is overly misunderstood and often confused with macroeconomic forecasting and early-warning indicator. Stress testing is not a standalone tool and it does not supplant other tools in the central bank’s arsenal; quite the opposite, stress testing is indispensable when complemented by another analytical method, model, or technique such as value-at-risk (VaR). Even though the five founding members of ASEAN-5 have made remarkable strides since the late 1990s in bringing their respective domestic banking sectors in line with the international standards (i.e. Basel III), they must continue with introducing more structural reforms and stay away from instability-inflicting policies.