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Stress testing banks

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  • Schuermann, Til

Abstract

How much capital and liquidity does a bank need to support its risk taking activities? During the recent (and still ongoing) financial crisis, answers to this question using standard approaches, e.g., regulatory capital ratios, were no longer credible, and thus broad-based supervisory stress testing became the new tool. Bank balance sheets are notoriously opaque and susceptible to asset substitution (easy swapping of high risk for low risk assets), so stress tests, tailored to the situation at hand, can provide clarity by openly disclosing details of the results and approaches taken, allowing trust to be regained. With that trust re-established, the cost-benefit of stress testing disclosures may tip away from bank-specific towards more aggregated information. This paper lays out a framework for the stress testing of banks: why it is useful and why it has become such a popular tool for the regulatory community in the course of the recent financial crisis; how stress testing is done (design and execution); and finally, with stress testing results in hand, how one should handle their disclosure, and whether it should be different in crisis vs. “normal” times.

Suggested Citation

  • Schuermann, Til, 2014. "Stress testing banks," International Journal of Forecasting, Elsevier, vol. 30(3), pages 717-728.
  • Handle: RePEc:eee:intfor:v:30:y:2014:i:3:p:717-728
    DOI: 10.1016/j.ijforecast.2013.10.003
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    References listed on IDEAS

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    1. Antonella Foglia, 2008. "Stress testing credit risk: a survey of authorities' approaches," Questioni di Economia e Finanza (Occasional Papers) 37, Bank of Italy, Economic Research and International Relations Area.
    2. Stiroh, Kevin J, 2004. "Diversification in Banking: Is Noninterest Income the Answer?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 36(5), pages 853-882, October.
    3. Bangia, Anil & Diebold, Francis X. & Kronimus, Andre & Schagen, Christian & Schuermann, Til, 2002. "Ratings migration and the business cycle, with application to credit portfolio stress testing," Journal of Banking & Finance, Elsevier, vol. 26(2-3), pages 445-474, March.
    4. Acharya, Viral V. & Bharath, Sreedhar T. & Srinivasan, Anand, 2007. "Does industry-wide distress affect defaulted firms? Evidence from creditor recoveries," Journal of Financial Economics, Elsevier, vol. 85(3), pages 787-821, September.
    5. Donald P. Morgan, 2002. "Rating Banks: Risk and Uncertainty in an Opaque Industry," American Economic Review, American Economic Association, vol. 92(4), pages 874-888, September.
    6. Ingo Fender & Michael S. Gibson & Patricia C. Mosser, 2001. "An international survey of stress tests," Current Issues in Economics and Finance, Federal Reserve Bank of New York, vol. 7(Nov).
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    More about this item

    Keywords

    Capital requirements; Leverage; Systemic risk;

    JEL classification:

    • G20 - Financial Economics - - Financial Institutions and Services - - - General
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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