Bank Stress Testing

VAR does not purport to account for extreme losses.This is why VAR should be complemented by stress testing which aims at identifying situations that could create extraordinary losses for the institution.

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Stress testing is a key risk management process which includes

1. scenario analysis : it consists of evaluating the portfolio under various states of the world.

2. stressing models :  it involves evaluating the effect of changes in valuation models, as well as in inputs such as volatilities and correlations.

3. developing policy responses consists of identifying steps the bank can take to reduce its risk and converse capital.

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Stress tests fall into three categories:

These scenarios can be created using a variety of methods.

a.  Scenarios requiring no simulation : 

     This approach is backward looking and does not account for changes in portfolio composition.

b.   Scenarios requiring a  simulation: 

These consist of running simulations of the current portfolio subject to large hsitorical shocks - for example stock market crash of 1987 , the ERM criseis of September 1992, the bond market rout of 1994 and so on.

c.   Bank-specific scenarios : 

Creating prospective scenarios should be tailored to the portfolio at hand.

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Stress-testing is useful to guard against event risk.

Goal of Stress-testing is to identify areas of potential vulnerability.

The objective of stress-testing and management response should be to ensure that the institution can withstand likely scenarios without going brankrupt.

Institutions should stress-test their market and credit exposure, taking into account the concentration risk to groups of counter parties and the risk that liquidating positions could move the markets.

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