Designing Macroeconomic Scenarios for Stress Testing

Mark M Zandi

Since the financial crisis broke, central banks around the world have taken unprecedented steps to revive the global economy. Ultra-low interest rates and ballooning central bank balance sheets have been the subject of much debate. Receiving much less attention, but arguably just as important, are the stress tests that financial regulators now require large institutions to take.

Stress testing emerged in the US and UK during the height of the financial crisis in early 2009. The financial system had suffered a near-death experience: major institutions had failed, stock markets had fallen and credit markets had frozen. While governments managed to prevent calamity through unprecedented fiscal and monetary policy actions, no one knew whether this would be a temporary fix or a lasting cure. The US Treasury and Federal Reserve designed stress tests for the nation’s major financial institutions, to determine the amount of capital needed to restore their health to health. Banks were required to quantify what could happen to their mortgages, credit cards and other portfolios if the economy suffered a downturn as severe as the 1930s Great Depression.

Many viewed the stress tests