Stress Testing in Financial Institutions

Sunil Verma

This article was first published as a chapter in Managing Illiquid Assets: Perspectives and Challenges, by Risk Books.

Since the last quarter of 2007 financial turmoil has created massive losses for various market participants (and probably will again at some time not too far in the future). Markets have witnessed a change from being a zero-sum game to an arena where all participants could stand to lose, leading to a general feeling of distrust among the participants of market mechanics. Various instances of restatements and failure of promises will only add to the mutual feeling of distrust. The impact of this financial turmoil scenario for bearing severities needs to be evaluated for various market participants. The impact of stress on the market participants and market instruments will lead to performance deterioration. This deterioration may result in investors and liability holders looking at losses in their income/investments. The chain of events and interrelatedness of the market participants may not stop at the direct dependents, such as banks or trading counterparties, but could permeate the entire fabric of the macroeconomy, leading to entire economies entering a