Stress testing is considered to be the best risk management tool for global banks. In fact, stress tests involve hunting down extreme possible scenarios that have very little chance of happening. Bank stress tests are not forecasts, as their primary purpose is to prepare financial institutions for a possible “stress.”

Thorough stress testing is an important part of every large financial organization’s workflow. They use it in order to gauge how their structure would behave under extremely difficult conditions. Bank stress tests offer a standard mechanism for companies to assess the risks and evaluate the impact of these extreme conditions.

Global financial institutions need to conduct stress tests in order to ensure that they are able to withstand various financial emergency situations. They want to make sure that they can stay solvent during severe economic challenges.

As a matter of fact, since the 2008 financial crisis, global regulators have issued strict requirements in relation to the type and severity of risk scenarios that financial institutions should use annually.

Stress testing also offers an opportunity to evaluate a company’s operational readiness to respond to a crisis.

For instance, one of the global regulatory bodies, the European Banking Authority (EBA) has the responsibility to ensure the proper functioning of financial markets and the soundness of the financial system in the EU.

In order to do that, EBA “is mandated to monitor and assess market developments as well as to identify trends, potential risks and vulnerabilities stemming from the micro-prudential level.”

EBA’s EU-wise stress tests are carried out in a bottom-up fashion. The organization is utilizing methodologies, scenarios, and key assumptions that were developed in collaboration with the ESRB, the European Central Bank (ECB) and the European Commission (EC).

In the same fashion, the Federal Reserve of the US carries out annual supervisory stress tests of banks with $50 billion or more in assets. The key goal of this stress test is to find out whether a bank has enough capital to properly function during tough times.

Following on this, stress tests at private mortgage lenders are conducted twice a year, as they also have to comply with strict reporting deadlines.

One of the possible hypothetical scenarios that are provided for financial institutions’ stress testing is as follows: the unemployment rate is at 10 percent, with a general 15 percent drop in stocks, and a 30 decline in home prices.

This hypothetical situation is then used by the banks to determine if they have sufficient capital to make it through the “fake” crisis. Banks usually use the next nine financial quarters of planned financials for this purpose.

Banks and other financial institutions that conduct regular stress tests are obliged to publish their results. These results are then made public to present how the bank would manage its operations during a major crisis.

In addition, a set of new global regulations requires companies that do not pass these tests to reduce their dividend payouts and share buybacks to preserve capital.

It happens that banks are given a conditional pass of a stress test. This implies that a bank almost failed a stress test and its ability to make further distributions in the future are at risk. Banks that pass on a conditional basis need to resubmit their plans of actions.

What happens when banks fail stress tests?

Banks that fail stress test risk severely damaging their public image – they are seen as unreliable and the public believes that they would not be able to withstand a financial disaster. Nevertheless, some global major banks have failed stress tests numerous times.