What is stress testing?
Stress testing is a method of quantitative financial market analysis used to assess the resilience of individual banks and the banking system as a whole. It involves the design of (stress) scenarios and the analysis of the impact of those scenarios. Supervisors use stress tests to evaluate the capitalization and liquidity situation of individual banks, comparing hypothetical losses – under the assumptions of the relevant scenario – with existing buffers. Apart from that, stress tests are also applied in financial stability analysis to assess systemic risk, in particular interactions between individual banks. Here, the impact on the entire banking system of stress scenarios for the real economy are investigated; therefore, these stress tests are also called macro stress tests.
How are stress test scenarios constructed?
The stress test scenarios chosen by supervisors should be severe but plausible. They should simulate a serious threat to banks’ viability while being realistic and credible at the same time. At the OeNB, developing the scenarios for Austria, Europe and the rest of the world, taking into account the characteristics of the Austrian banking system, is therefore a joint effort of the business areas dealing with banking supervision, macroeconomic and financial stability issues. These jointly developed scenarios are the basis for the calculation of risk factors, such as credit defaults or stock prices.
Banks first used stress tests in market risk management. In the 1990s, stress tests were carried out to calculate valuation effects in the case of adverse price developments, e.g. interest rate or exchange rate movements. Reflecting the importance of stress testing in financial stability analysis, the very first issue of the OeNB’s Financial Stability Report (published in the first half of 2001) featured an article on stress tests. Since then, the OeNB has published a number of other studies dealing with various aspects of banking system stress tests.
Stress testing as it is carried out today has been promoted on a global scale especially by the International Monetary Fund (IMF) under its Financial Sector Assessment Program (FSAP). In Austria, it was under the first FSAP in 2003 that the OeNB conducted its first large-scale stress test. Much of the earlier research work fed into this stress testing exercise for the Austrian banking system. Numerous scenarios were applied to assess credit and market risk as well as contagion risk in the domestic banking sector and liquidity risk.
Stress testing in Austria
Since these first stress testing exercises, the OeNB has cooperated with Austrian universities and technical colleges to do pioneering work in stress testing. OeNB experts, for instance, developed the Systemic Risk Monitor (SRM), a truly innovative tool – both from an academic perspective and from the practitioner’s view – that has earned international recognition. The SRM allows analysts to simulate multiple scenarios, thereby enabling them to assess key risk categories (credit and market risks) simultaneously and quantify the potential effects of contagion between banks.
The SRM has since been developed further and replaced by ARNIE (Applied Risk Network and Impact assessment Engine), which continues to be used frequently in off-site analysis today. Furthermore, under the second FSAP in 2007, the OeNB for the first time involved banks in the calculation of macro stress tests. Between 2007 and 2014, banks used to run bottom-up stress tests whereas the OeNB would run top-down scenarios, analyzing the selected scenarios in parallel. This approach has since become best practice in and outside of Austria. Ever since the European Central Bank (ECB) became responsible for supervising the largest banks, bottom-up stress tests have been conducted by the ECB, while the OeNB continues to run top-down stress tests. The OeNB publishes aggregate results in its Financial Stability Report.
Stress testing in Europe
The global financial crisis and the bank stress tests conducted in its wake in the U.S.A. in 2009 familiarized a broader public with stress testing. In Europe, the European Banking Authority (EBA) and the European Systemic Risk Board (ESRB) jointly coordinate stress tests comparable to those conducted in the U.S.A. Carrying out these stress tests is the responsibility of the ECB and the national supervisory authorities, i.e. in Austria the OeNB and the Financial Market Authority (FMA). Clearly, such an international exercise requires an enormous amount of coordination. However, the effort pays off: Supervisors, market participants and the general public benefit from comparable data and consistent risk assessments.
Furthermore, large-scale stress tests receive public attention, which contributes to substantial capital increases both in the run-up to the test and after results have been published, and therefore also improve banks’ resilience. Yet not all EU-wide stress tests have run entirely smoothly in the past. Therefore, the EBA and the ESRB are continually working to improve multilateral quality assurance processes. Despite the high expectations placed in stress tests, it should be borne in mind that stress testing is not a panacea for financial stability problems, just a method of quantitative financial market analysis.