In general terms, a stress test is a tool to measure the stability of a financial institution by concocting and applying hypothetical situations and analyzing how the institution would fare. Typically, these hypothetical situations involve negative events or worst-case scenarios. The stress test will analyze the institution’s assets and liabilities at their true values to determine if the institution has sufficient financial wherewithal to survive the hypothetical economic event.
Stress testing can be performed by a financial institution to gauge its ability to handle events that would negatively affect either the institution or the economy as a whole. However, governments can also order stress testing to help ensure large institutions will not collapse as a result of negative economic events. Thus, stress testing can be a valuable tool in managing risks to a financial institution as well as to entities in other sectors.
Rao Chalasani is the former Director of Trading, Risk Management, and Business at Bank of America in New York, NY. In addition to his risk management work at BofA and other financial institutions, including JP Morgan Chase and Merrill Lynch, Mr. Chalasani, who now lives in New Jersey, is the inventor of an "Enterprise Risk Management System," on which a patent is pending.