Stress Testing as a Banking Risk Assessment Tool: A Review of International Practice, Methods and Methodology

Abstract

Stress testing is a broad research area, at the interference of many disciplines (finance, banking, econometrics, macroeconomics, microeconomics, mathematical analysis etc.), and is of interest to both theoretical scientists and practitioners. The usefulness of this approach became evident after the financial crisis of 2007–2009, which prompted many researchers to develop and constantly improve stress-testing methodologies, using which it is possible to accurately forecast the behavior of banks and the financial sector in crisis periods. It allows banks to assess the scale of losses and timely take the necessary measures to strengthen the financial condition. Today, economic science has the biggest arsenal of stress testing methods that allow us to assess potential losses in crisis periods that correspond to extreme but plausible events. The stress testing methodologies cover all-important types of risks (credit, interest rate risk, liquidity risk etc.), as well as specific risks. The presence of a huge number of stress testing methods guarantees its versatility and depth, which could be explained by the attempt using this methods to create a behavior model of banks, which are quite complex in structure and functionality. The purpose of this study is to provide a concise, but at the same time comprehensive classification of stress testing methods, as well as a review of the current approaches to stress testing or to solving its various aspects (for example, developing stress scenarios) presented by scientists, international organizations, central banks and other interested parties. This paper is an introduction to the vast field of analytics – stress testing, and is oriented to banking and financial analysts, macroeconomists who want either to familiarize themselves with stress testing as a tool for assessing banking risks, or to systematize all the accumulated knowledge in this area in order to better understand economic processes.