Principles for sound stress testing practices and supervision

The depth and duration of the financial crisis has led many banks and supervisory authorities to question whether stress testing practices were sufficient prior to the crisis and whether they were adequate to cope with rapidly changing circumstances. In particular, not only was the crisis far more severe in many respects than was indicated by banks’ stress testing results, but it was possibly compounded by weaknesses in stress testing practices in reaction to the unfolding events. Even as the crisis is not over yet there are already lessons for banks and supervisors emerging from this episode.

Stress testing is an important risk management tool that is used by banks as part of their internal risk management and, through the Basel II capital adequacy framework, is promoted by supervisors. Stress testing alerts bank management to adverse unexpected outcomes related to a variety of risks and provides an indication of how much capital might be needed to absorb losses should large shocks occur. While stress tests provide an indication of the appropriate level of capital necessary to endure deteriorating economic conditions, a bank alternatively may employ other actions in order to help mitigate increasing levels of risk. Stress testing is a tool that supplements other risk management approaches and measures. It plays a particularly important role in:

  • providing forward-looking assessments of risk;
  • overcoming limitations of models and historical data;
  • supporting internal and external communication;
  • feeding into capital and liquidity planning procedures;
  • informing the setting of a banks’ risk tolerance; and
  • facilitating the development of risk mitigation or contingency plans across a range of stressed conditions.

Download to read more

Back to: