What Is a Bank Stress Test? How It Works, Benefits, and Criticism

What Is a Bank Stress Test?

A bank stress test is an analysis conducted under hypothetical scenarios designed to determine whether a bank has enough capital to withstand a negative economic shock. These scenarios include unfavorable situations, such as a deep recession or a financial market crash. In the United States, banks with $50 billion or more in assets are required to undergo internal stress tests conducted by their own risk management teams and the Federal Reserve.

Bank stress tests were widely put in place after the 2008 financial crisis. Many banks and financial institutions were left severely undercapitalized. The crisis revealed their vulnerability to market crashes and economic downturns. As a result, federal and financial authorities greatly expanded regulatory reporting requirements to focus on the adequacy of capital reserves and internal strategies for managing capital. Banks must regularly determine their solvency and document it.

How a Bank Stress Test Works

Stress tests focus on a few key areas, such as credit risk, market risk, and liquidity risk to measure the financial status of banks in a crisis. Using computer simulations, hypothetical scenarios are created using various criteria from the Federal Reserve and International Monetary Fund (IMF). The European Central Bank (ECB) also has strict stress testing requirements covering approximately 70% of the banking institutions across the eurozone. Company-run stress tests are conducted on a semiannual basis and fall under tight reporting deadlines.

All stress tests include a standard set of scenarios that banks might experience. A hypothetical situation could involve a specific disaster in a particular place—a Caribbean hurricane or a war in Northern Africa. Or it could include all of the following happening at the same time: a 10% unemployment rate, a general 15% drop in stocks, and a 30% plunge in home prices. Banks might then use the next nine quarters of projected financials to determine if they have enough capital to make it through the crisis.

Historical scenarios also exist, based on real financial events in the past. The collapse of the tech bubble in 2000, the subprime mortgage meltdown of 2007, and the coronavirus crisis of 2020 are only the most prominent examples. Others include the stock market crash of 1987, the Asian financial crisis of the late 1990s, and the European sovereign debt crisis between 2010 and 2012.

Benefits of Bank Stress Tests

The main goal of a stress test is to see whether a bank has the capital to manage itself during tough times. Banks that undergo stress tests are required to publish their results. These results are then released to the public to show how the bank would handle a major economic crisis or a financial disaster.

Regulations require companies that do not pass stress tests to cut their dividend payouts and share buybacks to preserve or build up their capital reserves. That can prevent undercapitalized banks from defaulting and stop a run on the banks before it starts.

Sometimes, a bank gets a conditional pass on a stress test. That means the bank came close to failing and risks being unable to make distributions in the future. Reducing dividends in this way often has a strong negative impact on share prices. Consequently, conditional passes encourage banks to build their reserves before they are forced to cut dividends. Furthermore, banks that pass on a conditional basis have to submit a plan of action.

Criticism of Bank Stress Tests

Critics claim that stress tests are often overly demanding. By requiring banks to be able to withstand once-in-a-century financial disruptions, regulators force them to retain too much capital. As a result, there is an underprovision of credit to the private sector. That means creditworthy small businesses and first-time homebuyers may be unable to get loans. Overly strict capital requirements for banks have even been blamed for the relatively slow pace of the economic recovery after 2008.

Critics also claim that bank stress tests lack sufficient transparency. Some banks may retain more capital than necessary, just in case requirements change. The timing of stress testing can sometimes be difficult to predict, which makes banks wary of extending credit during normal fluctuations in business. On the other hand, disclosing too much information could let banks artificially boost reserves in time for tests.

Real World Examples of Bank Stress Tests

Many banks fail stress tests in the real world. Even prestigious institutions can stumble. For instance, Santander and Deutsche Bank failed stress tests multiple times.