Wikipedia states a Stress Test “is a form of testing that is used to determine the stability of a given system or entity. It involves testing beyond normal operational capacity, often to a breaking point, in order to observe the results. Stress testing may have a more specific meaning in certain industry”.
Under Financial Stress Test, it goes on to explain, “Instead of doing financial projection on a “best estimate” basis, a company or its regulators may do stress testing where they look at how robust a financial instrument is in certain crashes, a form of scenario analysis”.
Stress tests focus on a few scenarios – such as credit risk, market risk, and liquidity risk – to banks’ financial health in emergency situations. The results of stress tests depend on the assumptions made in various economic scenarios. These situations have been developed and defined by the International Monetary Fund as “unlikely but plausible.”
A financial stress test is only as useful as the eventualities on which it is based. Those planning stress tests must literally imagine possible futures the monetary system may be confronted by.
As an exercise of the imagination, the stress test is restricted by the imaginative capacities of those planning the strain test eventualities.
Often , the test’s designers fail to picture credible future eventualities, doubtless due to pro peer pressure or groupthink inside a line of work or trade (witness the failure of the majority of fiscal “experts” to visualize the crash of 2008 ) or because some things are just too impossible to envision.
The successive finance stress tests conducted by the European Banking Authority and the Panel of European Banking Supervisors in 2009, 2010 and 2011 illustrate this dynamic. The 2009 and 2010 stress tests thought even in their detrimental eventualities a comparatively benign macro-economic environment of -0.6% commercial expansion in the eurozone area ; by 2011 it was clear that such guesses were no longer just credible, they were virtually certain to occur ; the unfavorable eventuality needed to be altered to a -4.0% expansion eventuality.
Those reviewing and using the result of stress tests must use a critical eye on the eventualities utilized in the test. Financial Institutions and Consumer groups have been at odds over the recession. The Finance Services Roundtable in a note indicated the jobless rate hasn’t gone over 11%, not to mention reach the 13% provided in the stress test scenario or not since the Great Depression.
Noted that there’s a baseline eventuality that observers should inspect and the target of the exercise is to check for all remote possible events no matter how likely. “Certainly no-one predicted the amount of stress the bank system went thru in 2008,
If you see what is occurring in Europe and doomsday circumstances with sovereign default, it behooves the Federal Reserve to be certain the bank system is as safe as possible.
The US economic future relies on the confidence of the American public in the banking system.