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Stress-testing is an exercise used to gauge the financial resilience of banks under adverse scenarios. Regulators require banks to undergo periodic stress-testing of varying degrees of severity, to ensure they will be able to withstand future economic shocks. In some cases, banks whose stressed capital falls below a minimum set by regulators are prohibited from making capital distributions, such as dividends and stock repurchases.
Some stress tests, including the US Federal Reserve’s Comprehensive Capital Analysis and Review (CCAR) and Dodd-Frank Act Stress Test (DFAST), as well as programmes conducted by the Bank of England, are run annually; others, such as the European Banking Authority’s EU-wide stress test, are run every two years.
Macroeconomic scenarios are a key component of stress tests. Regulators set values for broad financial parameters, such as changes in GDP, unemployment or commodity prices. Firms are then required to model how their business would perform under those conditions. The amount of capital a bank will need to hold is contingent on the severity of the scenarios used in stress tests.
Stress tests are intended to assess not only quantitative measures of financial health but also the quality of a firm’s risk governance and control processes. A well-designed stress-testing framework should incorporate clearly defined roles and responsibilities for model development and validation, scenario design, use of stress test outputs, and reporting and challenge of results.
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