Financial Sector Assessment

Stress Testing

This technical note is intended to answer some of the questions that may arise as part of the process of stress testing a financial system. The note is structured as follows: Section D.1 begins with a discussion of stress testing in a financial system context that highlights some of the differences between stress testing that is designed to identify systemic weak­nesses and stress testing within individual portfolios. Section D.2 provides an overview of the process itself—from identifying vulnerabilities, to constructing scenarios, to interpret­ing the results. Section D.3 shows some examples of stress-testing calculations. Section D.4 draws on experience in conducting stress testing as part of the Financial Sector Assessment Program (FSAP).

D.1 Overview of Stress Testing1

A stress test is a rough estimate of how the value of a portfolio changes when there are large changes to some of its risk factors (such as asset prices). The term rough estimate is used to avoid the perception that stress testing is a precise tool that can be used with scientific accuracy. Stress testing is an analytical technique that can be used to produce a numerical estimate of a particular sensitivity. Stress tests usually produce a numerical estimate of the change in value of the portfolio that has been caused by exceptional, but plausible, shocks. This change is often expressed in terms of the effect on some measure of capital as a way of understanding the sensitivity of the net worth of the institution to the risk being considered. The stress-testing process, however, is more than just applying a set of formulas to spreadsheets of numbers; it involves a series of judgments and assumptions that can be as critical to producing meaningful results as the actual calculations them-

selves. Each assumption, aggregation, or analytical approximation made in the process can introduce wide margins of error to the results; therefore, much care should be taken in their estimation and interpretation.

The use of stress tests has broadened over time. Stress tests were originally developed for use at the portfolio level to understand the latent risks to a trading book from extreme movements in market prices. They have now become widely used as a risk management tool by financial institutions (see, e. g., Committee on the Global Financial System 2000). Gradually, the techniques have been applied in a broader context, with the aim of mea­suring the sensitivity of a group of institutions (such as commercial banks) or even an entire financial system to common shocks. Stress-testing results may be compared across institutions, and the aggregate effect may be viewed as a change in financial soundness indicators (FSIs) caused by a common shock. The dispersion of the estimated effect among institutions of a common shock by itself produces valuable information on the potential for systemic risk.

System-focused stress tests, as the name implies, have several important differences from portfolio-level stress tests. The ultimate intent of system-focused approaches is dif­ferent, because they aim to identify common vulnerabilities across institutions that could undermine the overall stability of the financial system. The focus is also more macro­economic in nature, because the investigator is often interested in understanding how major changes in the economic environment may affect the financial system. A second difference between system-focused and portfolio-level stress tests lies in the complex­ity and degree of aggregation. System-focused stress tests may involve aggregation and comparison of more heterogeneous portfolios, often on the basis of different assumptions and methods of calculation. This aggregation requires adding or comparing “apples” and “oranges” to a much greater extent than is the case for a single institution’s portfolio.

System-focused stress tests can be classified according to two types: either simultaneous stress tests of multiple portfolios using a common scenario, or a single scenario applied to an aggregated portfolio or model of the entire system.2 Constructing an aggregated portfo­lio or model with sufficient detail is often an arduous and complex task. Therefore, most system-focused stress tests have adopted the first approach of applying a common scenario to a variety of institutions. This approach has the advantage that it provides informa­tion on the overall effect of shocks, as well as their distribution throughout the system, which can be useful for understanding the potential for contagion and confidence effects on stability. If data availability allows, conducting both types of tests—on an aggregated portfolio, as well as on individual portfolios—will provide the maximum information on a system’s vulnerabilities.