Stress Testing Practice for Risk Management

Abstract

Risk-management practices at financial institutions have undergone a quantitative revolution. Increasingly, financial firms rely on statistical models to measure and manage financial risks, ranging from market risks (such as exchange rate fluctuations) to credit risks (such as borrowers' default probabilities) to operational risks (such as expected losses due to fraudulent transactions). Such models have gained credibility because they provide a coherent framework for identifying, analyzing and communicating these risks. These are only simplifications of reality and cannot capture every aspect of these risks. For example, unlikely yet possible events that could cause significant losses are not captured readily by models constructed to monitor typical risk outcomes. To address this shortcoming, risk managers have developed a practice known as which also has become an important element of the supervisory monitoring of financial firms. Indeed, many supervisory agencies have begun using stress-testing techniques to assess the capital adequacy of individual firms and even national financial systems. We define stress testing, describe its possible applications, and highlight certain techniques developed to conduct this testing, and survey its recent use by supervisory agencies. The European Union plans to conduct its bank stress tests as an industry wide look at the health of the financial system. That way, it is expected that an overall view of the euro zone's banking system will be obtained. The European bank stress test results should be ready by September, in the hopes that the information will be helpful for junior finance ministers and central bank representatives at their autumn meeting.