The Advancement of Stress Testing at Banks

Michel Araten

This chapter will trace the use of stress testing by banks from its precursors to its application following the imposition of regulatory stress tests. It begins with an examination of the origins of stress testing as firms first sought ways to measure risk beyond simple sensitivity analyses that were applied to a base set of assumptions underlying capital investment decisions. The application of simulated outcomes to probabilistic events led to capital modelling as a way to quantify measures of uncertainty. Economic capital modelling of losses gave banks tools to assess risk-adjusted returns on capital. A number of case examples will be used to illustrate some of the early approaches to stress testing that banks used to explore the robustness of their economic capital models and loss estimates.

While Basel II provided the impetus for regulators to charge banks with more formalised approaches for estimating regulatory capital, it was only after the emergence from the financial crisis of 2007–08 that stress testing became an important regulatory tool to measure the adequacy of banks’ capital planning processes. The impact of the heightened expectations for both regulatory capital