Operational Risk: An Overview of Stress-Testing Methodologies

Brian Clark and Bakhodir Ergashev

Numerous international regulatory standards require the implementation of stress testing as a risk-management tool. The Basel Committee on Banking Supervision (2009) (henceforth BCBS), a key international regulatory guidance on stress testing, recommends including stress tests in a bank’s overall risk-management toolkit. The document broadly refers to stress tests as “the evaluation of a bank’s financial position under a severe but plausible scenario”. It provides general principles for stress testing practices, while allowing banks ample discretion in choosing stress-test methodologies. However, the document refrains from prescribing any particular stress-testing approach, thereby leaving banking institutions with broad discretion in choosing stress-testing methodologies.

The purpose of stress testing is often viewed by regulatory bodies and financial institutions as a means to determine how a financial institution’s capital or financial position would be impacted on by an adverse scenario. In most applications, this requires modelling a link between a macroeconomic event or series of macroeconomic events and the performance of a bank’s portfolio of assets. In the context of