Stress Test

A financial test applied by rating agencies to assess the claims-paying ability of debtors and guarantors like bond insurers. The stress test for instance subjects a bond insurer´s portfolio to a severe and prolonged economic downturn that produces an extraordinary level of bond defaults. In order to receive a AAA rating on its claims-paying ability, a bond insurer must be able to pay all projected claims through the peak years of the stress period and be left with sufficient resources to write new business when more stable economic conditions resume.
Financial tests carried out by financial supervisors to ascertain the capital adequacy of the institutions supervised. Stress testing exercises are widely used by financial institutions in assessing their exposures to credit and other risks. Stress tests can also help policymakers to gauge the potential implications of differing risks for the stability of the financial system as a whole. And in recent years, there has been a burgeoning interest in such systemic stress testing among central banks and international organisations.
Stress testing is an appealing risk-management tool because it provides risk managers with additional information on possible portfolio losses arising from extreme, although plausible, scenarios. In addition, stress scenarios can often be an effective communication tool within the company and to outside parties, such as supervisors and investors.
Stress-testing techniques fall into two general categories: sensitivity tests and scenario tests. Sensitivity tests assess the impact of large movements in financial variables on portfolio values without specifying the reasons for such movements. These tests can be run relatively quickly and are commonly used as a first approximation of the portfolio impact of a financial market move. However, the analysis lacks historical and economic content, which can limit its usefulness for longer term risk-management decisions.
Scenario tests are constructed either within the context of a specific portfolio or in light of historical events common across portfolios. In a stylized version of the specific portfolio approach, risk managers identify a portfolio´s key financial drivers and then formulate scenarios in which these drivers are stressed beyond standard VaR levels. For the event-driven approach, stress scenarios are based on plausible but unlikely events, and the analysis addresses how these events might affect the risk factors relevant to a portfolio.
The choice of portfolio-based or event-based scenarios depends on several factors, including the relevance of historical events to the portfolio and the resources available for conducting the exercise. Historical scenarios are developed more fully than hypothetical scenarios. Risk managers always face a trade-off between scenario realism and comprehensibility; that is, more fully developed scenarios generate results that are more difficult to interpret.
With respect to credit risk, stress testing is of two main types: stress testing of credit spreads, such as corporate bond spreads, in trading portfolios and the less frequent stress testing of loan portfolios. For stress testing of loan portfolios, variables such as borrower credit ratings and collateral values are stressed, often using scenarios based on shocks to the macro-economy. Stress testing is hampered by the lack of sufficient historical data, a lack of trading in certain credit instruments and differences in accounting treatment.