The financial crisis has illustrated how important it is to be aware of the financial system's vulnerability to different kinds of economic shocks. Stress testing is a quantitative method developed to shed light on this vulnerability. It estimates the impact on one or more banks' profits and financial strength of severe, though plausible, economic shocks.
Stress testing has been part of many banks' internal risk assessment since the early 1990s and was also adopted at an early stage by Norwegian banks. Stress testing requirements were included in the capital adequacy rules under the Basel II framework. Stress tests are for example used to estimate capital needs under Pillar 2. Over the past decade, stress testing has also increasingly been used by central banks and supervisory authorities to assess risk in the financial system as a whole (8), such as the Supervisory Capital Assessment Program (SCAP), conducted by the Federal Reserve in 2009, and the EU-wide stress test exercise carried out by the CEBS (Committee of European Banking Supervisors) in 2009 and 2010 (see Box 1). After the financial crisis, liquidity stress testing was introduced in addition to testing for solvency. Liquidity stress tests will not be discussed in this article. (9)
The authorities conduct stress testing in two different ways. (10) In one approach, stress testing is conducted by financial institutions based on a macro scenario specified by the authorities. This test is known as a bank stress test, or the "bottom-up" approach, referring to the way the test focuses on how the macro scenario affects risk in each of a bank's loans and then aggregates the overall impact on banks' profits and capital adequacy. Another approach is that often used by central banks, or the "top-down" approach, also referred to as macro stress testing. The main objective of macro stress testing is to assess systemic risk.
A macro stress test does not include detailed information on individual loans, and assessments of a bank's portfolio are primarily based on publicly available information. (11) Norges Bank's approach is a typical example (for a more detailed description, see Box 2).
Both methods have their strengths and weaknesses. The advantage of bank stress testing is that the individual bank is in the best position to assess risk in its own portfolio. The bank can, in principle, assess how the macro scenario affects the risk related to each exposure. As such, bank stress tests can provide a more complete picture of an individual bank's risk profile compared with macro stress tests. On the other hand, comparing bank stress test results across institutions is not straightforward. Differences in the results do not only reflect vulnerability, but may also reflect banks' varying interpretations of the impact of the macro scenario and the use of different calculation methods. A macro stress test ensures consistency in the assessment of each of the banks. Moreover, risk assessment is conducted from an overall perspective, which may provide a more accurate picture of risk in the banking system as a whole.
Box 1 The Supervisory Capital Assessment Program (SCAP) 2009 and the EU-wide stress test 2010 The Supervisory Capital Assessment Program 2009 (SCAP) In spring 2009, the US authorities conducted a stress test of the 19 largest US bank holding companies. The purpose of the stress test exercise was to assess whether banks had sufficient capital to absorb elevated loan losses in the event the economy, already in a recession, should deteriorate further. The sample covered around 3/4 of bank holding companies' total assets. Each SCAP bank was asked to conduct a stress test on the basis of two scenarios drawn up by the Federal Reserve. The scenarios comprised projections of key US economic data, including GDP, unemployment and house prices. The baseline scenario reflected the consensus expectation about the duration and depth of the recession, while the more adverse scenario was designed to reflect a further severe weakening of the US economy. The Federal Reserve estimated the probability of the alternative scenario occurring at 10-15%. The results of the exercise showed that under the alternative scenario, 10 of 19 banks would need to increase common equity by a total of USD 75bn in order to satisfy the capital adequacy requirements under the SCAP. (1) Financial institutions were given six months to raise the necessary capital, and if capital was unavailable from private sources, the US authorities would provide funds to recapitalise SCAP banks to enable them to maintain normal lending. The SCAP process went far in restoring confidence in the US banking sector and thus helped to stabilise the financial system. (2) Publishing bank-specific results provided the market with full information about banks' actual financial situation. This was important at a time when markets had reflected considerable uncertainty. By the end of November 2009, all banks that had been directed to raise additional capital had done so from private sources. EU-wide stress test 2010 In 2009 and 2010, the Committee of European Banking Supervisors (CEBS) (3) conducted stress tests of the largest European banking groups. In 2011, a similar test was conducted by CEBS's successor, the European Banking Authority (EBA). The objective of the EU-wide stress tests is to assess the resilience of European banks to adverse economic developments, while providing an overall assessment of risk in the EU financial system. The European financial sector is relatively heterogeneous, with regard to both bank structure and individual member states' regulatory environments. Thus, the use of common macroeconomic scenarios will facilitate comparison of stress test results across banks. The CEBS designed the macroeconomic scenario in collaboration with the European Commission and the European Central Bank (ECB). The national supervisory authorities followed up the dialogue with banks. As in the SCAP, the scenarios proposed by the CEBS had a two-year time horizon, though were specified in considerably more detail. One reason is that the EU-wide stress test also focused on market risk and sovereign risk. Neither of the two stress tests focused directly on liquidity risk. Banks participating in the EU-wide stress test covered around 65% of the European banking market in terms of total assets. The baseline scenario for the EU-wide stress test was based on the European Commission's projections from autumn 2009 and February 2010, which assumed a gradual recovery in Europe. Unemployment was expected to remain high. The adverse scenario comprised three main elements: a global expectation shock that would result in a double dip recession, an EU-specific yield-curve shock and country-specific shocks to reflect uncertain government finances. The reduction in output for the EU countries as a whole was about at the same level as the fall in output in the SCAP, about 3 percentage points lower than the baseline scenario over the two years. The results of the exercise showed that under the adverse scenario, 7 of 91 banks would need to increase Tier 1 capital by a total of EUR 3.5bn (USD 4.5bn) to keep their capital ratios above the threshold set out in this comparison. (4) Of the seven, five were Spanish savings banks, in addition to the German Hypo Real Estate Holding and the Agricultural Bank of Greece. The stress tests exceeded market expectations to a considerable extent, and the EU-wide stress test thereby helped to restore confidence in the European banking sector. Publishing bank-specific results provided the market with full information about banks' actual financial situation. Publishing banks' exposures to sovereign debt in particular helped to reduce market uncertainty and mitigate the fear of a new financial crisis. The EU-wide stress test has subsequently been subject to substantial criticism, aimed in particular at the test's failure to foresee the problems that materialised in the Irish banking sector three months after the CEBS published the stress test results. However, the problems arising in Irish banks in autumn 2010 were not only due to the fear of loan losses, but were primarily related to liquidity problems at Irish banks because they were unable to compensate for the sharp drop in deposits by obtaining alternative funding. As mentioned above, the EU-wide stress test did not focus directly on liquidity risk. The European stress tests also had a relatively short perspective. The stress tests performed by the Central Bank of Ireland in March 2011 take into account lifetime losses on the largest Irish banks' loan portfolios and weaker economic developments over time, resulting in greater losses for Irish banks, but also greater credibility in the long run. Although the Norwegian bank stress test has several similarities with the EU-wide stress test, there are also fundamental differences. As in the EU-wide stress test, the Norwegian bank stress test primarily focuses on...