Stress Testing to Manage Risks in Financial Institutions

The stability of financial systems is vital to the economy. The recent 2008 crises have shown how individual crises within financial organizations can quickly get converted into a systemic crisis. Regulators want to avoid such systemic crises at all costs. Over the years, they have used several analytical techniques that would enable them to predict and manage such crises. Stress testing is one such technique that is widely used.

In this article, we will understand what stress testing is as well as how it is used to ensure the stability and continuity of the financial system as a whole:

What is Stress Testing?

Stress testing is a type of simulation model which is used to manage risks in banks and other financial institutions. As a part of stress testing, various mathematical and analytical techniques are deployed to understand how an organization would react to adverse outcomes in the external environment. Stress testing is useful to understand how a portfolio would behave if several unforeseen circumstances took place simultaneously. These simulations are not performed by normal risk management models since they are considered to be outliers. However, the entire purpose of stress testing is to verify whether the financial system is equipped to deal with exceptional situations if the need arises.

How is Stress Testing Conducted?

Stress testing is conducted by creating scenarios that mimic the external world. In order to be able to do so, the financial analyst needs to have a clear understanding of the factors which impact the value of underlying assets.

A combination of these factors is then called a scenario. Scenarios can be drawn up in one of two ways. Firstly, scenarios can be created based on hypothetical data. This means that it is assumed that extreme financial events that happened in the past are about to reoccur. However, what happened in the past, many not necessarily repeat in the future. Hence, financial analysts have to get creative and think about the various scenarios which could possibly happen in the future.

After these scenarios are identified, the performance of an institution or even the entire system needs to be simulated. This means that a financial model must be prepared, which can predict how the system will react if a particular scenario actually takes place. This would involve identifying the assets which would face stress and the corresponding fall in their value. Simultaneously, the value of other assets may increase. This should also be considered in the stress test.

The possible courses of action which can be taken should also be considered. The financial impact of the decisions taken in each case should be noted down. The results can then be shared in a training session with the decision-makers. This would enable them to manage an adverse situation better as and when it occurs.

Is Aggregate testing of the Financial System Different Than Testing of Individual Organizations?

The aggregate stress testing of the financial system is quite different from the testing of an individual firm.

• To begin with, the objective of an aggregate stress test is quite different from an individual stress testing. Aggregate tests are done in order to understand the breaking point wherein the entire financial system will collapse. On the other hand, individual stress tests are done to understand how a particular company can reduce its exposure to the amount of risk in the economy. The decisions taken at the end of both types of stress tests are very different. Regulators make decisions about changing the rules and regulations in the marketplace in order to make it safer and more effective. On the other hand, individual companies take decisions which help them decide the appropriate level of leverage which they should maintain

• Another important point to consider is that when stress testing is done for the entire financial system, it becomes difficult to define the word "system." When the portfolio of the entire system is to be considered, firstly, the firms which need to be added in the analysis need to be defined. Banks and major financial institutions are always considered to be a part of the system. The problem is about which smaller firms need to be included in the analysis.

• Also, when the system as a whole is considered, a complex set of interlocking financial claims need to be identified. As a result, finding the net exposure of the system as a whole can be quite complex.

The degree of integration with other financial systems also makes it difficult to conduct stress testing. If the market has a lot of foreign investors from a different country, then their markets will also be adversely impacted by the negative events happening in a different country. On the other hand, if these external institutions guarantee the financial well being of their local subordinates, then even the impact of local conditions is reduced significantly. Foreign banks and companies can potentially transmit as well as absorb shocks based on their financial standing. This impact is difficult to gauge while conducting a stress test.

The methodology of stress testing also needs to be decided beforehand. The results of the stress test can be very different if the stressor factors are applied to the entire system vis-a-vis if they are applied to individual firms in the system.

The bottom line is that stress testing is a very important method for gauging the stability of the financial system. However, it is quite complex, which makes it difficult to execute in real life.

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