how a bank stress test works
stress tests focus on a few key areas such as credit risk market risk and liquidity risk to measure the financial status of banks in a crisis using computer simulations hypothetical scenarios are created using various criteria from the federal reserve and international monetary fund imf the european central bank ecb also has strict stress testing requirements covering approximately 70 of the banking institutions across the eurozone 3 company run stress tests are conducted on a semiannual basis and fall under tight reporting deadlines all stress tests include a standard set of scenarios that banks might experience a hypothetical situation could involve a specific disaster in a particular place a caribbean hurricane or a war in northern africa or it could include all of the following happening at the same time a 10 unemployment rate a general 15 drop in stocks and a 30 plunge in home prices banks might then use the next nine quarters of projected financials to determine if they have enough capital to make it through the crisis historical scenarios also exist based on real financial events in the past the collapse of the tech bubble in 2000 the subprime mortgage meltdown of 2007 and the coronavirus crisis of 2020 are only the most prominent examples others include the stock market crash of 1987 the asian financial crisis of the late 1990s and the european sovereign debt crisis between 2010 and 2012 in 2011 the u s instituted regulations that required banks to do a comprehensive capital analysis and review ccar which includes running various stress test scenarios 4benefits of bank stress teststhe main goal of a stress test is to see whether a bank has the capital to manage itself during tough times banks that undergo stress tests are required to publish their results these results are then released to the public to show how the bank would handle a major economic crisis or a financial disaster regulations require companies that do not pass stress tests to cut their dividend payouts and share buybacks to preserve or build up their capital reserves that can prevent undercapitalized banks from defaulting and stop a run on the banks before it starts sometimes a bank gets a conditional pass on a stress test that means the bank came close to failing and risks being unable to make distributions in the future reducing dividends in this way often has a strong negative impact on share prices consequently conditional passes encourage banks to build their reserves before they are forced to cut dividends furthermore banks that pass on a conditional basis have to submit a plan of action criticism of bank stress testscritics claim that stress tests are often overly demanding by requiring banks to be able to withstand once in a century financial disruptions regulators force them to retain too much capital as a result there is an underprovision of credit to the private sector that means creditworthy small businesses and first time homebuyers may be unable to get loans overly strict capital requirements for banks have even been blamed for the relatively slow pace of the economic recovery after 2008 critics also claim that bank stress tests lack sufficient transparency some banks may retain more capital than necessary just in case requirements change the timing of stress testing can sometimes be difficult to predict which makes banks wary of extending credit during normal fluctuations in business on the other hand disclosing too much information could let banks artificially boost reserves in time for tests real world examples of bank stress testsmany banks fail stress tests in the real world even prestigious institutions can stumble for instance santander and deutsche bank failed stress tests multiple times 5