Financial Sector Assessment

Interpretation and Publication

Experience in conducting stress tests suggests they are a useful tool for identifying the latent risk exposures and the likely significance of losses in a systematic and intuitive manner. Stress tests can be particularly useful when they are conducted on a regular basis, thereby providing information about changes in the risk profile of the system over time. Although stress test results are useful to evaluate effects of large movements (tail events) in key variables, care should be taken not to portray them as providing a precise measure of the magnitude of losses. Stress tests can indicate how much could be lost but not how much is likely to be lost.

Interpretation of stress tests needs to take into account their limitations. If the under­lying model is incorrectly specified or estimated, the conclusions drawn from a stress-test may be invalid. Stress tests are also unlikely to capture the full range and interaction of risk exposures (such as operational risk and legal risk) and may give a misleading picture of the true nature of risk taking by participating institutions. Finally, stress tests typically consider only part of a bank’s income-generating operations. Thus banks may have sig­nificant income flows that are unaffected in performance or value by the specific stress test scenarios analyzed.

An overview of the stress tests results can be conveyed by grouping the aggregate effect of the stress tests by type of risk or by scenario. The composition of expected losses (as a proportion of capital or income for instance) can be used to summarize the central results. For bottom-up approaches, descriptive statistics (e. g., mean, median, standard deviation, minimum, maximum, and number of institutions in each decile) and peer group analysis can be used to convey how the effect at the aggregate level is distributed across individual institutions.

Public dissemination of the results of stress tests can present some difficulties with regard to confidentiality and interpretation of results. Participating institutions may be reluctant to have any information disclosed that could identify specific firms. Some ana­lysts may interpret the particular scenarios chosen as reflecting an official view on the most likely scenario or the most problematic, which may not be the case. Nevertheless, the publication of summary or aggregated information on stress test results by a wide variety of countries suggests that those difficulties can be overcome. Disclosure of some summary information on the results (such as the mean and the range) can be informa­tive for financial markets and individual institutions wishing to benchmark their own results against their competitors without revealing the identities of individual institutions. Disclosure of the scenarios undertaken can also raise awareness of different risks for insti­tutions to consider and incorporate into their own stress-testing programs.

D.3 Examples of Stress-Testing Calculations

Stress tests can be applied to both assets and liabilities and can be used to assess vari­ous risks: market risk (possibility of losses from changes in prices or yields), credit risk (potential for losses from borrower defaults or nonperformance on a contract), liquidity risk (possibility of depositor runs or losses from assets becoming illiquid), or contagion risk (possibility of losses resulting from failures in other financial institutions). Stress tests usually produce a numerical estimate of the portfolio’s change in value—often expressed in terms of the effect on a measure such as the capital asset ratio or risk-weighted capital adequacy ratio—to

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