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Are there best practices in stress testing for banks?

Checking if a bank can cope with a crisis has yet to find its way in the governance structures of banks, says Martin Maurer, secretary general of the Association of Foreign Banks in Switzerland

January 28, 2011 | Aditya Puri

Stress tests are undertaken to analyse the impact of external, and possibly internal, effects on a bank’s exposures and profits and losses. Properly done, they are an important strategic tool. They are not a daily risk management tool, but help monitor a bank’s solvency and evaluate the impact of changing external situations, internal processes and  new products. They support strategic decisions.

The macro-prudential stress tests, which the US Treasury and European banking supervisors undertook in recent years, looked at interactions at network effects by defining a stress situation for all institutions. This has led to a debate over whether these stresses were really stressful. Besides this, determining which situation to stress test is also extremely difficult to determine on a macro level.

Defining stress tests is an art, not a science. The real challenge is to define a plausible and relevant shock for the bank, and to apply it. There is an infinite number of events you can use, and there is the danger that the test is used to paint a situation that is either too rosy or overly bleak. Moreover, there is the danger of stressing negative occurrences of the past instead of likely future problems. As with all such tools, there is also an over reliance on the results—in a highly non-linear world, a situation which deviates relatively little from the stressed situation can bring about very different results.

It is more important to believe in stress tests, rather than taking them just as an element in the whole risk management and risk control process. Stress tests give a very good idea of the effect on—and, if done properly, on the sensitivity of—a bank to a particular event. But they provide no guarantee that the results will be accurate in the case that the event occurs. Also, if the event occurs as perceived, the network effect in the whole system may change the effect on the bank.

I am very sceptical about what is a ...

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Credit Risk, Risk And Regulation Working Group

Keywords:Market Risk