Techniques, Purpose, and Real-World Examples

What Is Stress Testing?

Stress testing is a technique used to assess the stability of financial institutions and investment portfolios against possible future financial situations. The financial industry customarily uses such testing to help gauge investment risk and the adequacy of assets and evaluate internal processes and controls.

Other industries, such as engineering and software development, use stress testing to assess the capabilities of products and services.

Stress Testing Applications in Various Industries

Stress testing is used in many industries to check the strength and reliability of systems and products. In engineering and manufacturing, stress testing finds out the limits of materials and components. This involves putting materials under high pressure, temperature, or mechanical strain to find breaking points and ensure they meet safety standards.

Software stress testing involves pushing applications to their limits by simulating high traffic, processing large amounts of data, or running the software for extended periods to identify potential failure points. This type of testing helps developers ensure that applications can handle real-world demands such as high user loads during peak usage times without crashing or slowing down.

In healthcare, stress testing can take on a more literal meaning. Medical stress tests, such as those used in cardiology, involve placing the human body under physical stress to monitor how the heart and other systems respond. This type of testing is used to diagnose diseases. By monitoring the body’s response to stress, healthcare providers can make informed decisions about patient care and treatment plans.

How Financial Institutions Use Stress Testing

Asset management companies use stress testing to identify portfolio risk and set hedging strategies to prevent losses. Specifically, their portfolio managers use internal proprietary stress-testing programs to evaluate how well the assets they manage might weather certain market occurrences and external events.

Asset and liability matching stress tests are widely used, too, by companies that want to ensure they have the proper internal controls and procedures in place. Retirement and insurance portfolios are also frequently stress-tested to ensure that cash flow, payout levels, and other measures are well aligned.

Regulatory Requirements for Stress Testing in Banks

After the 2008 financial crisis, bank regulations expanded, emphasizing stress testing and capital adequacy due to the 2010 Dodd-Frank Act.

Starting in 2011, U.S. regulations required banks to submit Comprehensive Capital Analysis and Review (CCAR) documents. These regulations require banks to report on their internal procedures for managing capital and carry out various stress-test scenarios.

In addition to CCAR reporting, banks in the United States deemed too big to fail by the Financial Stability Board—typically those with more than $50 billion in assets—must provide stress-test reporting on planning for a bankruptcy scenario. In the government’s most recent reporting review of these banks in 2018, 22 international banks and eight based in the United States were designated as too-big-to-fail.

Currently, BASEL III is also in effect for global banks. Much like the U.S. requirements, this international regulation requires documentation of banks’ capital levels and the administration of stress tests for various crisis scenarios.

Exploring Different Stress Testing Techniques

Stress testing involves running simulations to identify hidden vulnerabilities. The literature about business strategy and corporate governance identifies several approaches to these exercises. Among the most popular are stylized scenarios, hypotheticals, and historical scenarios.

Historical Stress Testing

In a historical scenario, the business—or asset class, portfolio, or individual investment—is run through a simulation based on a previous crisis. Examples of historical crises include the stock market crash of October 1987, the Asian crisis of 1997, and the tech bubble that burst in 1999-2000.

Hypothetical Stress Testing

A hypothetical stress test is generally more specific, often focusing on how a particular company might weather a particular crisis. For example, a firm in California might stress-test against a hypothetical earthquake or an oil company might do so against the outbreak of war in the Middle East.

Stylized scenarios are a little more scientific in the sense that only one or a few test variables are adjusted at once. For example, the stress test might involve the Dow Jones index losing 10% of its value in a week.

Simulated Stress Testing

As for the methodology for stress tests, Monte Carlo simulation is one of the most widely known. This type of stress testing can be used for modeling probabilities of various outcomes given specific variables. Factors considered in the Monte Carlo simulation, for example, often include various economic variables.

Companies can also turn to professionally managed risk management and software providers for various types of stress tests. Moody’s Analytics is one example of an outsourced stress-testing program that can be used to evaluate risk in asset portfolios.

Pros and Cons of Stress Testing

Stress tests help banks understand their financial position and risks for the future. They guide managers on actions to take and how to reduce risks if events occur. As a result, they are better able to form action plans to thwart threats and prevent failure. Investment managers can assess how well assets might perform in economic downturns.

To perform stress tests, financial institutions need to create the framework and processes for which the tests can be performed. This restructuring is complex and is often associated with costly mistakes. For example, it’s possible that the test scenario does not represent the types of risks a bank may face. This may be due to insufficient data or the test designer’s inability to create a relevant test. In the end, the results of the test may lead to the creation of plans for events not likely to occur. This misrepresentation can cause institutions to ignore the risks that are possible.

Lastly, banks with unfavorable results may be barred from paying dividends to their customers and shareholders, as well as may be penalized.

Practical Example: Stress Testing at Financial Institutions

Banks and financial institutions often use the Federal Reserve’s Dodd-Franklin Act Stress Test (DFAST) and Comprehensive Capital Analysis and Review (CCAR) stress test.

The Federal Reserve administers the Comprehensive Capital Analysis and Review stress test annually for banks with at least $100 billion in assets. This test identifies whether banks have sufficient capital to operate during economic downturns and plans in place to address such events and other associated risks. Specifically, the Federal Reserve looks at the bank’s capital, its plans for its capital (e.g., dividends), and how it assesses capital needs.

The Dodd-Franklin Act Stress Test (DFAST), required for banks with at least $250 billion in assets, is often used in conjunction with the CCAR. This test can be conducted directly by the Federal Reserve or by financial institutions under the direction of the Fed. This, like the CCAR, reviews whether a bank or financial institution has enough capital to account for losses and continue operations in the event of economic turmoil.

Both tests have similar goals but are done differently to cover various events and risks.

 The Bottom Line

Stress tests can be effective analytical tools in identifying whether a company has sufficient capital, strong assets, and effective plans to weather an economic storm. Companies can use historical, hypothetical, or simulated events to create test scenarios, or they may be required by a regulatory body to perform certain tests. The results can help financial institutions and banks identify risks and formulate action plans to prevent potential failures.