Bank stress tests are conducted to test an institution’s financial capacity to withstand tough economic conditions. The stress tests are mathematical forecasts of what could happen if a bank were exposed to negative conditions, such as high unemployment and falling oil prices. They are performed by the bank’s internal risk management team and reported to the Federal Reserve.
Because many banks were unprepared for the financial crisis of 2008, many were left severely undercapitalized. Stress tests were established to prevent such eventualities by ensuring that banks have sufficient capital and strong financials.
In the United States, all banks with over $50 billion in assets are required to take the Federal Reserve (the Fed) stress test. Every year, the Fed publishes hypothetical scenarios of tough economic situations, such as a falling stock market or high unemployment. Banks then calculate how their investments and loans would fare if these conditions lasted a full nine quarters. They then submit their results to the Fed.
The Fed assesses the results of each bank, analyzing each one based on their quantitative ability to maintain a predetermined minimum capital base in such tough times, and their qualitative ability to handle the risks they will be exposed to, including credit risk and market risk.
The results of Fed stress tests are published to improve the public’s confidence in the banking industry.