Bank stress tests are special analyses that a government authority or company runs to determine the strength of a bank to resist difficult economic times. They conduct such tests using economic conditions that are unfavorable to learn if the banks possess sufficient capital to survive the effects of negative financial environments. In the United States, the law requires that banks which claim at least $50 billion worth of assets must perform their own internal stress tests. Their risk management department is responsible for overseeing these. The Federal Reserve conducts these stress tests on such banks as well.
The idea behind these bank stress tests is to look at several critical risks which can afflict the banks and banking system. They are supposed to evaluate the financial condition of the bank being tested in one or more crisis scenarios with regards to liquidity risk, market risk, and credit risk. The tests simulate fictitious potential crises using a number of different factors that the International Monetary Fund and Federal Reserve determine.
This mostly came about after the worldwide financial crisis and Great Recession of 2007-2009. As many banks had failed or nearly collapsed, government and international bodies became more concerned about checking on the financial strength of banks in potential crisis scenarios.
These bank stress tests were effectively set up and used on a widespread basis after this worst collapse since the Great Depression of the 1930s. The financial crisis had left in its wake a number of financial institutions, investment banks, and commercial banks that had insufficient capital. The stress tests were established to deal with this threat before it became severely problematic again.
There are two main types of bank stress tests that exist. The Federal Reserve runs its own yearly oversight stress tests of the U.S. banks that have at least $50 billion in assets on their balance sheets. The primary purpose of such a stress test is to learn if the banks possess sufficient capital to weather the storm of challenging economic conditions.
The company operated stress tests are done twice a year by law. They must be strictly reported according to the deadlines set by the Fed. Results must be turned in to the Federal Reserve board by no later than January 5th and July 5th.
In either of the stress tests, the banks receive a typical set of circumstances to evaluate their performance. It might be a 30% free fall in the prices of housing, a 5% to 10% decline in the stock market, and a 10% or higher unemployment rate. The banks must then take their future nine quarters of financial forecasts to ascertain if their capital levels are sufficient to endure the hypothetical crisis.
These bank stress tests have broader repercussions. Banks must make public their results by publishing them after they undergo the tests. The pubic and investors then learn how the bank in question would survive in a significant crisis situation. Laws and regulations passed since the financial crisis require that companies which are unable to pass the stress tests must cut their share buyback programs and dividend payments so that they can preserve the capital they have.
There are cases where banks receive a conditional passing grade on a stress test. This result states that the bank nearly failed its test. It puts them at risk of not being allowed to engage in more capital distributions going forward. Conditional passing means that a bank has to turn in a plan of action to address the capital shortfall.
These failures cause a bank to look bad to not only investors but the banking public. There have been a number of banks that failed such stress tests. Foreign banks like Germany’s Deutsche Bank and Spain’s Santander have failed to pass such tests on a number of occasions.