Stress testing is a risk-management technique that evaluates how an institution, portfolio or system would perform under severe but plausible adverse conditions. It applies hypothetical or historical shock scenarios to estimate losses, capital depletion and liquidity strain beyond normal expectations. Supervisory stress tests are a central tool of prudential regulation for assessing resilience and informing capital requirements.
Overview
- Routine risk measures capture normal conditions; stress testing probes the extreme tail where institutions fail.
- Tests apply hypothetical or historical shocks to balance sheets, exposures and funding.
- Supervisory stress tests aggregate across firms to gauge systemic resilience and set capital expectations.
- Reverse stress testing instead asks which scenarios would render a firm non-viable.
Mechanisms
- Scenario design specifies adverse macroeconomic and market paths.
- Loss projection models translate scenarios into losses and capital impacts.
- Sensitivity and reverse tests explore single-factor shocks and breaking points.
- Capital and liquidity metrics are recomputed under stressed conditions.
Applications
- Bank capital adequacy assessment under regulatory frameworks.
- Insurance solvency and reserve resilience testing.
- Portfolio and trading-book risk evaluation.
- System-wide macroprudential surveillance by central banks.