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What Is Stress Testing?

HOW DO WE KNOW if a financial system is healthy? liquidity, whether they have enough cash to pay
Can banks survive a recession if half of their out their deposits and other debts. Let’s say a bank
mortgage clients lose their jobs and stop paying loses $1 billion when house prices drop by 50 per-
their debts? Do insurers have enough money to cent. The bank can survive—remain solvent—if
pay out claims if a magnitude 8 earthquake hits its capital is $10 billion but not if it is $1 billion.
Tokyo? Answers to these types of questions lie What if a bank’s depositors panic and suddenly
in stress tests. withdraw $50 million? If the bank is unable to
Attention to stress testing shot up during the borrow money to replace those deposits, it can
2008 global financial crisis, when banks and other survive if it owns assets, such as government bonds,
financial firms lost vast sums of money. Major that it can sell quickly.
long-established institutions—such as Lehman
Brothers—went belly-up. Others required multi- Severe but plausible
billion-dollar taxpayer-funded bailouts. People did A key stress testing ingredient is an adverse scenario
not know if their bank would be around tomorrow. that is severe yet plausible. A severe scenario sup-
National authorities of crisis-hit economies started poses a low-probability event that nevertheless has
to use stress tests extensively to reduce uncertainty potentially catastrophic consequences. Examples
ART: ISTOCK / RASTUDIO

over bank health and decide what to do about vul- include a once-in-a-century earthquake, a repeat
nerable banks. of the 2008 financial crisis, or a government debt
Stress tests typically cover solvency—whether default. Plausible scenarios exclude absurd hypo-
banks have enough capital to absorb losses—and theticals, such as a Martian invasion. Historical

52 FINANCE & DEVELOPMENT | September 2019

scenarios are useful but may not capture novel Transitional risk could stem from the decline of the
risks. For example, major disruptions caused by coal industry in response to the adoption of a carbon
new financial technology or climate change have tax. As these companies lose money, they may default
not yet happened, but they are plausible. on their loans, reducing their banks’ profits. Bonds
Designing scenarios starts with a list of potential and equities issued by these firms would lose value,
risks specific to a country. Examples include a major inflicting losses on investors.
decline in manufacturing in an economy that relies The IMF adopted stress testing in response to the
heavily on factory production or a terrorist attack in Asian financial crisis of 1997 and was among the
a country dependent on tourism. Stress testers then first institutions to do so. Stress tests figure in the
develop a story line for the scenario and estimate Financial Sector Assessment Program for member
how variables such as GDP and interest rates react. countries run jointly by the IMF and the World
To understand how an adverse scenario affects Bank since 1999. A distinctive feature of IMF stress
bank health, stress testers first gauge how bank tests is their focus on the financial system as a whole
clients would behave under such circumstances. rather than on individual institutions. Once iden-
To do that, they may need to calculate how many tified, the assessment recommends ways national
households and companies would continue paying authorities can reduce risks before they materialize
their debts if the economy were to take a dive, and and control the damage if they come to pass.
how they might draw down their bank deposits. When the global financial crisis struck in 2008,
Stress testers then measure how this behavior would authorities in the United States, the euro area,
affect banks’ liquidity and capital. and elsewhere adopted stress tests and made the
Because of the connections among banks, the results public as a way of bolstering confidence in
failure of some of them could ripple through the the financial system. Unlike IMF tests, their main
financial system, doing damage to the broader focus is to identify weaknesses in individual banks
economy. What would happen, for example, if and consider measures to restore them to health
banks stopped lending? Companies might need or close them.
to shrink their operations and lay off employees.
Without mortgages, families might not be able to Use only as directed
buy homes. To be useful, stress tests must employ reliable,
timely, and detailed data. Historical data should
Emerging risks cover turbulent episodes as well as periods of calm.
Stress tests often focus on banks because of their size Incomplete or inaccurate data yield unreliable
and importance to the economy. But other finan- results that may provide a false sense of comfort.
cial service providers and sources of finance, such Finally, stress tests are not stand-alone tools.
as bond sales, have been growing rapidly. So stress Full-fledged risk analysis should combine stress
tests increasingly cover mutual funds, insurance tests with other quantitative and qualitative tools.
companies, and other nonbank service providers Moreover, assessments of financial stability should
as well as novel sources of risk. For example, recent be complemented by an examination of a country’s
IMF stress tests have examined how the rise of new financial sector policies, oversight framework, and
financial technologies could squeeze the profits of financial safety nets (for example, the existence and
existing financial service firms. Banks’ growing scope of deposit insurance). When carried out as
dependence on third parties for services such as cloud part of such a comprehensive, in-depth assessment,
computing raises new challenges for stress testing. stress tests are quite powerful.
Another evolving challenge is climate change,
which poses two types of risk, physical and tran- MARTIN ČIHÁK is a division chief, HIROKO OURA is a
sitional. Physical risks can already be seen in deputy division chief, and LILIANA SCHUMACHER is a
the increasing frequency and intensity of floods, senior economist, all in the IMF’s Monetary and Capital
droughts, and other natural disasters. Insurers Markets Department.
selling building and disaster insurance could lose
money. Or they may increase premiums so much To learn more about stress testing, visit www.elibrary.
that many households can no longer afford coverage. imf.org and type “stress testing” in the search bar.

September 2019 | FINANCE & DEVELOPMENT 53