Within months of the financial downturn, regulators began to fortify the financial sector with stress testing. It opened eyes in Wall Street, and many “too big to fail” banks, to perils only they had invited.
Initially, regulators faced heavy criticism for the objective and purpose of stress testing. However, Critics are now changing their opinions after realizing how banks are successfully able to manage economic stress, volatile market conditions, capital capabilities, liquidity vulnerabilities, credit tensions and operational glitches using the approach. Overall, stress testing gives you a measure of financial health.
Before we dwell deeper into the subject, let me address what risk managers would often ask – “what exactly is stress testing?”
In simple words, stress testing is a methodology by which you devise worst-case crisis scenarios under the existing organizational environment. The testing enables you to analyse the ability of financial institutions to deal with such situations. Moreover, it exposes the nature of stability in the enterprise.
These adverse scenarios can cause an economic downturn, increase the rate of unemployment, inflate the rate of interest and prices in general, or demolish house and stock prices. The devised events of stress testing address plights at micro and macro levels, specific to the economy, industry or the institution itself.
Banks that are able to consume the loss and stand up to recommended capital requirements pass the stress test. Regulators deem them qualified to continue with their lending activities.
What are the benefits of carrying out stress tests?
Regulators have constructed stringent and streamlined stress tests and bankers find themselves on pins and needles whenever you talk about it. However, the boards need to realize that there are many positives from stress tests that can benefit them:
- Discover unexpected risks
Stress tests enable institutions to understand the probability and impact of projected risk events. Known consequences, in fact, prepare banks to be better equipped with defense strategies.
- Compare peer standards
Understand the sensitivity of each bank to different shock scenarios and scale them against each other. It helps institutions to create a broader business strategy involving aggressive risk management, wherein factors like liquidity risks are taken into account.
- Global nexus of financial and economic events
Like in the 2007-08 financial disaster, economic shifts can impact financial services, and vice-versa. The interconnections between banks transmitted shocks regionally and beyond national boundaries, resulting in large-scale losses.
Stress tests are a medium to recognize these interlinked elements. It assesses the probability of contagious threats and the impact it has on the stability of the entire financial system.
The flood of new rules and increase in regulatory expectations are making stress tests no easy for the money-lenders. Regulatory testing requirements are pushing financial institutions towards risks like committing to higher operational overheads. That ensues mainly from inadequate systems and processes. At the same time, evolving firms perceive the situation as an opportunity to adopt proactive risk management solutions and stress testing in their strategic business tools.
Driven by failures in the past, regulators are assertive about checking the lending capacity of financial institutions, especially the big-belly banks. An under-capitalized financial sector is not something the world economy can endure again.
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