EU-wide Stress Tests: Rationale and Basics

Piers Haben and Mario Quagliariello

WHAT IS A STRESS TEST?

In the typical textbook definition, a stress test is a forward-looking tool that allows for an estimation of the impact on banks of an extreme but plausible shock. In some cases, such an estimate can be a relatively accurate prediction of how risk exposures change in value under stress conditions; more often, however, stress tests only provide a rough approximation of what may happen to a specific portfolio in an adverse scenario. In that respect, a stress test is not different from any “what-if” analysis run to understand the consequences on a set of key indicators of possible future states of the world.

Large banks have been running simulations of how their balance sheets would fare in the face of external shocks, in both quantitative and qualitative forms, for many years, and basic stress tests have been run on large banks since the 1990s. The practice is borrowed from other industries. In a straightforward manner, data-based stress tests stem from efforts in the 1960s to assess profitability distributions to stimulate output-variable probability distributions (see Hertz, 1964), but in a much more general sense the philosophical approach is borrowed