Stress testing in banks – more important in 2023 than ever before

Banks and other financial institutions form the core infrastructure of the world’s economy. They are key in facilitating international trade and in supporting the service sector, both locally and globally. Banks are also present in our everyday life. They provide numerous payments, savings and lending services. This includes helping us paying our everyday expenses, saving our monthly salaries and getting a mortgage. So, banks, and especially healthy viable banks, are highly essential. Stress testing in banks is like a health inspection to ensure banks are able to withstand and remain viable should there be an economic or financial downturn or crisis.

In this article we will discuss key aspects of stress testing and cover the following topics:

What is stress testing in banks?
What is the purpose of stress testing in banks?
A short history of stress testing in banks
How MORS can assist banks with their stress testing

What is stress testing in banks?

A bank stress test is an analysis conducted under hypothetical scenarios designed to determine whether a bank can withstand a negative economic development, or a shock. These scenarios include unfavourable situations, such as a recession or a financial market crash. The stress tests indicate how a bank would be affected in cases of severe but plausible negative scenarios. Ultimately, the stress tests verify if banks have enough capital to survive the scenario.

In the scenarios a number of variables are used. These include macroeconomic variables such as a severe decline in house prices, a rise in unemployment or a decline in GDP. The scenarios also include financial market variables such as changes in interest rates, changes in foreign exchange rates or a decline in stock markets. The scenarios and stress tests aim to answer the “what-if” question or questions. For example, “what-if” house prices decline by 10%, unemployment increases by 3% and interest rates rise by 2%?

Some of the stress tests are mandated and required by central banks or other supervisory authorities. Banks are required to run the stress tests with the stipulated variables and return the results of the tests to the regulatory authorities. Smaller banks are typically exempt from regulatory stress tests while the largest banks are required to perform the most stringent stress tests. Banks also perform internal stress tests. In the case of an internal stress test, the bank will design its own scenario and associated variables to be applied in the test.

The outcome of a stress test will help supervisory authorities and the banks themselves determine what actions might be required for the banks to remain healthy and viable businesses, even if unexpected and negative events occur. The potential actions include increasing the amount of capital or ‘own funds’ banks are required to hold, to be able to withstand the losses caused by negative events.

Although stress tests are powerful and offer a lot of insight, they are not a ‘cure all’ for the banking industry. Stress tests should be seen as one tool, of many, in keeping banks healthy and profitable.

What is the purpose of stress testing in banks?

On a high level, the overall purpose of stress testing is to measure the resilience of banks in adverse economic environments and in stressed financial markets. Some of the key tangible purposes of conducting the stress tests are listed below:

• The most important purpose of stress testing is to measure if the bank’s capital or own funds are sufficient in case of difficult periods when banks typically suffer losses. This information is valuable to the bank itself and tells the regulators if some action needs to be taken.
• Another key purpose of stress testing is to measure whether banks are holding enough liquid assets that can be easily monetised in times of stress in the market.
• By analysing and publishing the results of the stress tests, central banks and supervisory authorities can issue guidance and new regulation to improve the resilience of the banking industry.

A short history of stress testing in banks

Large banks have conducted internal stress tests for several decades, but it was in the aftermath of the 2008 global financial crises that mandatory stress tests were widely introduced. The introduction of mandatory stress tests has taken place worldwide, although there are significant differences between the laws and regulations of different countries and regions.

The global financial crisis exposed the vulnerability of many banks during the market crash and the recession that followed. This prompted governments, regulators, central banks and the whole banking industry itself to understand the consequences of the failure of global banks. The global banks are often referred to as “too big to fail” as the consequences of a global bank failing are likely to spread to the whole global economy. Even the failure of a large regional bank is likely to have an enormous impact on the local and regional economy. Mandatory stress tests and strict reporting requirements may help avoid future banking and economic crises.

EU-wide stress testing

In July 2023, the European Banking Authority (EBA) published the results of its 2023 EU-wide stress test of 50 banks. This EU-wide stress-test involved 70 banks from 16 EU and EEA countries, covering 75% of the EU banking sector assets. The results of the 2023 EU-wide stress test show that European banks remain resilient under an adverse scenario which combines a severe EU and global recession, increasing interest rates and higher credit spreads. You can read more about this on the EBA website.

How MORS can assist banks with their stress testing?

MORS Software is a complete solution to banks when they want to easily monitor, forecast and report their assets, liabilities and treasury. In addition MORS is a great tool for internal assessment processes and ad-hoc stress test requirements. What-if scenarios are easy to perform and over all the software is very flexible and intuitive in everyday use. Internal and regulatory stress testing is built-in-feature in MORS integrated ALM.

Benefits of MORS Integrated ALM approach in a nutshell:

• MORS is very user-friendly.
• MORS has intuitive scenario generation and stress testing functionality.
• MORS data is always up to date.
• The level of granularity and the overall quality of MORS data quickens good decision making.
• MORS forward-looking analytics drives profitability through balance sheet optimisation.
• MORS is highly cost efficient.
• New versions are always included in the MORS license.

Further questions on MORS and stress testing in banks

Please contact our experts if you would like to discuss how MORS can help you with stress testing. By engaging with us in a dialogue about your bank’s requirements, we will be able to help you fulfill your needs.

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References
Bank Stress Test, by Troy Segal, Reviewed by Margaret James.

European Central Bank, Bank Supervision, Supervisory Practices: Stress tests.

EBA European Banking Authority, News & Press.

Stress-testing banks during the Covid-19 pandemic, by Patrizia Baudino.