Stress Testing Foundations

Ahraz Sheikh

4.1 INTRODUCTION

This chapter describes the processes involved in conducting stress testing exercises within a bank. Chapter 1 describes stress testing as an exercise to determine bank resilience under various macroeconomic and financial scenarios. As described in Chapter 3, a scenario describes the evolution of risk factors (macroeconomic and financial) over a set time horizon. This time horizon is typically three to five years and corresponds to a bank’s “medium-term plan” (MTP).

Stress testing has its origins in engineering, which uses designs and prototypes to determine resilience under extreme environmental conditions. An example of this is river dam design, where stress tests are performed under potential flood, wind and plate tectonic (earthquake) conditions.

In the early days of bank stress testing (in the mid-1990s), it was seen as a complement to value-at-risk (VaR) measurements, especially for market risk. Prior to the 2007–12 global financial crisis (GFC), stress testing took two forms.

• 1.

  Univariate stress testing: this consisted of sensitivity analysis for individual risk factors under extreme moves, performed one factor at a time. This enabled quick