The Central Bank of Iceland’s approach to stress testing the Icelandic banking system

Stress testing banks is a way of examining the potential impact of hypothetical stress scenarios on the banking system and the institutions within it. Disclosure of stress tests, their results and methodology, can improve public understanding of risks related to the banks. It can also improve prudential policy-making and make policy more effective and credible. The Central Bank of Iceland (CBI) started to develop its current stress testing program in 2013 and the stress test and its results were first published in 2015. The stress scenario is designed with regard to the Bank’s assessment of current risks to financial stability in Iceland. In assessing the results of the stress test, the Central Bank uses a stress testing model of its own devising, but the impact of the stress scenario on the commercial banks’ balance sheets and profitability are also discussed with each bank. The stress tests are used in assessment of risks to financial stability, and also as a reference when decisions are made in connection with macroprudential tools, such as capital buffers. This report describes the framework and process of the Central Bank’s annual stress test, explains how the stress scenario is designed and discusses main aspects of Central Bank´s stress testing model.