Stress testing is a type of scenario analysis that looks at a financial outcome based on a specific “stress” placed on an entity. To evaluate the impact on the firm, this technique alters one parameter at a time.
In an economic crisis, for example, interest rates can change dramatically. The influence of this single parameter on the entity will be estimated through this. The revised ST exercises cover two strands of methodologies: Sensitivity Analysis and Scenario Analysis.
This is a vital tool that enables us to see the possible outcome of ‘low probability high severity events (or tail events)’. In stress testing, one should input some predefined scenarios into the model and estimate these scenarios’ effects. And the most crucial part of this is choosing scenarios. The approach we use in this is multivariate since we incorporate the correlation structure between innovations.
Example of Stress Testing
An example of stress can be an unexpected decline in the equity market impacting the index and, in turn, a bank’s investment fall by 20%, 30%, and 40% and its impact on the profitability and capital adequacy of the Bank.
Why is Stress Testing necessary?
Stress testing assesses investment risk, asset adequacy, and internal processes and controls. Regulations require banks to carry out various stress-test scenarios and report on their internal procedures for managing capital and risk. A stress test’s principal purpose is to determine whether a bank has enough capital to govern itself in difficult times.