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What are Bank Stress Tests?

During the financial crisis, government officials often talked about performing “stress tests” on the financial institutions to see how they would fare if the financial crisis worsened. I didn’t really understand what they meant by “stress tests” because I didn’t see how you could do traditional stress testing, as you would on like a chair, on a bank. If you’ve ever been to an IKEA, you’ve probably seen them demonstrate durability with stress tests (the classic robotic pushing down on the POÄNG Chair and the labeled floorboards that talk about the number of people who have walked over them), but how do you stress test a bank?

In reality, a bank stress test is simply scenario analysis. What would happen if the stock market, say the S&P500 index or the Dow Jones Industrial Index, fell by 20%? 50%? What happens if the yield on the 30 year Treasury increases or if the Fed increases the federal funds rate? Analysts run these various scenarios and look to see how the bank will perform (i.e. survive) under these extreme conditions.

In learning that’s what stress tests were, I was surprised these weren’t part of the usual risk analysis process. I’ve always understood risk analysis to be a look at the probability and severity of a event happening, it appears that banks, perhaps in their zeal, ignored anything with a low probability even if it might sink the firm. As an investor, I’d like to know what the various risks to a company should things go north or south.

Then again, when your bonus is tied to annual performance, big wins in 2010 followed by catastrophic losses in 2011 still means a huge 2010 bonus. 🙂